Case Study: CTD and Repo Arbitrage

DB Bank is believed to have pocketed over EUR100 million (USD89.4 million) after reportedly squeezing repo traders in a massive interest-rate futures position. The bank was able to take advantage of illiquidity in the cheapest-to-deliver bond that would have been used to settle a long futures position it entered, in a move that drew sharp criticism from some City rivals.

In the trade, the Bank entered a calendar spread in which it went long the Eurex-listed BOBL March 01 future on German medium-term government bonds and sold the June 01 contract to offset the long position, said traders familiar with the transaction. One trader estimated the Bank had bought 145,000 March 01 contracts and sold the same number of June 01 futures. At the same time the Bank built up a massive long position via the repo market in the cheapest-to-deliver bond to settle the March future, in this case a 10-year Bund maturing in October 2005.

Since the size of the 05 Bund issue is a paltry EUR10.2 billion, players short the March future would have needed to round up 82% of the outstanding bonds to deliver against their futures obligations. It is almost inconceivable that this many of the Bunds can be delivered, said a director-derivatives strategy in London. Typically traders would be able to rustle up no more than 25% of a cheapest-to-deliver bond issue, he added.

At the same time it was building the futures position, the Bank borrowed the cheapest-to-deliver bonds in size via the repo market. Several traders claim the Bank failed to return the bonds to repo players by the agreed term, forcing players short the March future to deliver more expensive bonds or else buy back the now more expensive future.

The Bank was able to do this because penalties for failure to deliver in the repo market are less onerous than those governing failure to deliver on a future for physical delivery. Under Eurex rules, traders that fail to deliver on a future must pay 40 basis points of the face value of the bond per day. After a week the exchange is entitled to buy any eligible bond on behalf of the party with the long futures position and send the bill to the player with the short futures position, according to traders. Conversely, the equivalent penalty for failure to deliver in the repo market is 1.33 bps per day (IFR, March 2001).

Questions Section

1. What is a calendar spread? Show DBs position using cash flow diagrams.