Commodities & Futures: Liffe spreads a little happiness

LIFFE has been laughing all the way to the bank since Danish voters rejected the Maastricht treaty on economic and monetary union. The political disarray has boosted volumes on the London Financial Futures and Options Exchange in an unexpected way.

The increased activity has been in an area called bond spreading, where a trader buys one bond and sells another simultaneously to take a view on the direction of interest rates.

The practice is not new: futures traders have been doing bond spreads since bond futures were invented, and bond dealers in the underlying 'cash' market probably originated them.

Liffe has built up a range of international interest rate contracts in its 10 years, and now offers six bond futures contracts covering sterling, the mark, the dollar, the Italian lira, the European currency unit, and the Japanese yen.

Executives at Liffe mean to make the most of the popularity of bond spreading. As of today, margins - the deposits traders must put down to cover the risk of trading each contract - will be reduced by 30 per cent on all Liffe bond futures and options spreads. Liffe hopes to lift volumes and give the exchange an attractive edge on European rivals.

Stephen Heuser, an independent trader and member of Liffe, said that much of the bond spreading had been based on the convergence theory, which suggested that European interest rates should gradually converge to a central rate.

Traders were buying bonds with high yields and selling bonds with low yields, anticipating that they would move together. The most fashionable spread play was buying the Italian bond (BTP) and selling the German bond (Bund).

'But when the Danes voted no, the whole convergence theory fell apart,' Mr Heuser said. 'There was suddenly no discipline on Italy to keep its economic house in order. There has been a sea change in views on the Ecu bond, Italian bond and French bond since the Danish vote' (on 2 June).

Many Liffe traders had been holding Italian bonds, thinking the yields would come down. But the referendum meant that Italian interest rates could stay high, and many traders decided it was best not to own Italian bonds. So they reversed their spreads, selling the Italian BTPs and buying Bunds.

The increased uncertainty has heated the BTP market and the contracts are now extremely volatile, which is exciting and risky for traders. For the first time in nearly five years, the spreads between major European government bonds are widening.

The explosion of the convergence argument for the time being has caused a doubling in Italian bond futures contracts traded on Liffe. In May, 293,000 BTP futures traded, and last month 640,000 changed hands.

Liffe began a series of briefings and international workshops on cross-currency spread trading last month, spurred by demand. More than 1,200 people have attended to find out how best to use the complex spreading techniques.

Mindful of the scandal on London Fox, London's commodity exchange, over market incentives to promote contracts, Liffe was only able to offer the margin reduction of 30 per cent on trading bond spreads because the risk of bond spreads was at least 30 per cent lower than putting on two independent bond trades, said Roger Barton, managing director of Liffe for business development.

Malcolm Roberts, head of bond research at UBS Phillips & Drew Securities, said the next key date would be the French referendum on 20 September.

The parliamentary process of ratification in Britain, Germany and Italy might also pose market threats, he said. That means the markets may remain a lively, though risky, place to do business.

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