Matt Levine, Bloomberg, Firm Sues to Stop CFTC From Calling It a Bunch of Cheaters. here.
Eventually, though, IDCH and Nasdaq convinced Jefferies to trade the contract, starting in 2010. This worked because Jefferies did not have a significant incumbent OTC swap business to protect, so it was open to exchange-based trading, and also because Jefferies was dumb and didn’t realize the contract was terrible. It missed the same thing that IDCH and Nasdaq missed, and just believed IDCH and Nasdaq when they said that the futures and swaps were equivalent.
Meanwhile, folks at DRW Investments also started trading the contract, because they were smart and saw that Jefferies were dumb. Basically, Jefferies took one side of a bunch of these contracts (receiving fixed), and DRW took the other on all of them (paying fixed)paid fixed on all of those contracts. The contracts were systematically mispriced: The fixed payer systematically should have paid more than it would under an equivalent swap, but since Jefferies believed that the futures and swaps were identical, it was willing to do the trades at the same rate as an equivalent swap. So DRW obliged (and, one assumes, entered into offsetting swaps, hedging out the interest rate risk and just pocketing the mispricing).
Rama Cont, Radu Paul Mondescu, and Yuhua Yu, SSRN, Central Clearing of Interest Rate Swaps: A Comparison of Offerings, here.
Abstract:Regulatory changes have motivated the development of a variety of solutions for the clearing of interest rate swaps. Margin payments associated with clearing lead to modifications in cash flows which result in differences in the valuation between cleared and non-cleared swaps. We propose a framework for computing these differences and show that they lead to two types of modifications in contract value: a convexity effect and a “Net Present Value” (NPV) effect, which can be significant for long-dated swaps. As a result, modifications in contract design are required in order for a centrally cleared interest rate swap to be economically equivalent to its uncleared counterpart. Among the currently available offerings for cleared interest rate swaps, three offerings are shown to be economically equivalent to their uncleared counterparts – the “Price Alignment Interest” method used by LCH. Clearnet and CME, as well as a new adjustment method used by the Eris Exchange – while a fourth method, used in the IDCG swap futures contract, is shown to lead to substantial deviations in valuation with respect to a non-cleared interest rate swap. Using a Hull-White model calibrated to the market data as of December 2010, we find the difference between the IDCG futures swap rate and the corresponding uncleared swap rate to be around 18 basis points for a 10 year contract and about 60 basis points for a 30 year contract. An interest rate environment with higher volatility will result in larger differences.
The Jefferies Group shows that fixed income isn’t necessarily for everyone. The revenue that the investment bank generated from trading bonds, currencies and commodities slumped 85 percent, to just $33 million, in the three months to September. That’s a far bigger drop than its larger rivals across Wall Street are expecting. As a relative newcomer, Jefferies appears to be struggling with volatility. The same may prove true for others that are downsizing their fixed-income businesses.
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