Prompted by $4 trillion (T) in federal government spending due to the Covid-19 pandemic, the U.S. Treasury drastically expanded the issuance of Treasury securities (bills, notes, and bonds) in 2020. While the issuance trend slowed in 2021 and 2022, the three years since the pandemic saw an average annual issuance of $19.1T, compared to an average annual issuance of $10.4T for the three years prior (2017 – 2019). 

The Federal Open Market Committee (FOMC) tasked with its dual mandate “of price stability and maximum sustainable employment” and facing an unprecedented contraction of demand, implemented several actions including reducing interest rates. The FOMC also instructed the Federal Reserve Bank of New York (Fed) to provide liquidity and stability to debt markets during the early stages of the pandemic. To do so, the Fed began purchasing Treasury securities and agency mortgage-backed securities (MBS) in March 2020. By April 2022, the Fed held $8.48T worth of Treasury securities and MBS on its balance sheet, up from $3.71T in January 2020, representing a 128% increase over that period.

The FOMC also took three other significant actions during this period. First, it reduced interest rates to zero and held them there until early 2022. Second, it reduced bank reserve requirements to 0%, meaning that depository institutions did not have to keep any cash on hand to cover its deposits. Third, and quite importantly, the FOMC temporarily (it was in effect from March 2020 to March 2021) changed the supplementary leverage ratio (SLR) that it implemented in 2014 to exclude U.S. Treasuries in the SLR.

As the increase in money supply worked through the financial system and landed as deposits, commercial banks had two choices: earn interest on excess reserves (IOER) or buy securities such as MBS and Treasuries. With low loan demand, a positive yield curve, and a dovish FOMC, purchasing U.S. guaranteed liquid securities seemed an appropriate investment.

Capital requirement rules favored this approach as well. While reserve requirements were eliminated, capital requirements remained unchanged. Capital charges for Treasury securities was and is 0%; capital charges for agency MBS ranges from 0 – 20% depending on the government agency issuing the debt.  

The end result is clear: commercial bank balance sheets grew tremendously. At the end of January 2020, commercial banks held $5.12T in Treasury securities and MBS; this reached a peak of $7.71T by the end of February 2022 representing a 29% increase in a little over two years.

While the actions of the Fed and commercial banks seem so similar that it gives the impression that they are acting under the same set of constraints, commercial banks do not have the ability to create reserve requirements (like the Fed does) for their depositors. Commercial banks are therefore exposed to the risk of deposit flight. 

Bank accounting practices are set by the Financial Accounting Standards Board (FASB) and are critical for understanding the liquidity position of a bank. According to FASB Statement No. 115, issued in May 1993, banks must classify debt securities in one of three categories: Available-for Sale (AFS) securities, Held-to-Maturity (HTM) securities, or Trading Securities (TS) on their balance sheet:

• AFS securities are intended to be held indefinitely but still sold prior to reaching their maturity date and are marked to market value for each accounting period. The unrealized gain or loss is recorded as Accumulated Other Comprehensive Income (AOCI) on a bank’s balance sheet, and realized gain or loss is reported on the income statement once a sale occurs.
• HTM securities are intended to be held until their maturity date and are not marked to market value. Instead, the original costs of acquiring a HTM security are amortized over the life of the asset on the bank’s income statement, and the original value of the security is reported on the balance sheet.
• Trading Securities are intended to be held for a short period of time (less than 12 months, but usually shorter than that in practice) and generate profits. The value of these securities is marked to market, but unlike AFS, the change in value is recognized on the income statement and is not recorded as AOCI on the balance sheet. 

Note: Given that most banks have the vast majority of their securities in either the AFS or HTM category, the content below will focus only on those two categories.

In the immediate aftermath of the pandemic, low interest rates increased the value of AFS securities – hence, bank security portfolios shifted to a higher proportion of AFS securities (AFS-to-HTM proportion was 78% to 22% at the end of Q2 2020). This put banks in a highly liquid position as they had a large supply of in-the-money AFS securities that they could immediately sell to meet demand deposits.

However, as interest rates rose, the proportion of AFS-to-HTM reversed: At the end of Q4 2022, following a nine-month period of rate increases, this proportion was 52% to 48%. Banks thus experience declining liquidity as they own securities that are not immediately available to sell. This creates a need to hedge balance sheet positions because capital is becoming more valuable in a tightening monetary environment.

Recent events have shown that deposits can leave and leave faster than ever given technology advances that allow deposit holders to move funds with a “click.” This stress was seen in market pricing of the Bloomberg Bank Yield Index that is built on actual trades of bank certificate of deposits, commercial paper, and deposits. Plotted against SOFR, it is easy to see that the market started pricing a premium for bank liabilities in the immediate aftermath of the recent bank crises. 

Moreover, changes to hedge accounting rules by FASB that went into effect in late 2022 make the accounting treatment of interest rate swaps used to hedge AFS portfolios more favorable. Previously, banks could only receive hedge accounting for hedges used on the portion of AFS assets that they believed would be outstanding for the longest period. The new rules allow for additional “layers” of security value to be hedged with hedge accounting even if the bank expects this portion of securities to be held for a shorter time frame. For more information, please refer to FASB’s website.  

CME Group offers a variety of solutions to commercial banks looking to hedge their balance sheet positions. Many of these products have been long used by banks to hedge their portfolios.  

Swap products

• Interest Rate Swap Clearing Interest rate swaps allow for parties to manage interest rate risk by exchanging a fixed rate for a variable one. Interest Rate Swap Clearing from CME Group is a robust and established business that offers real-time clearing, 24 hours a day, five days a week with significant margin offsets against listed interest rate futures and options products. In addition, beginning on April 21, 2023, CME Group will convert legacy USD LIBOR swaps to SOFR ahead of the June 30, 2023, discontinuation of LIBOR publication.

Eris Swap futures

• Eris Swap futures offer futurized swap exposure with margin offsets and flexible execution methods such as CLOB, privately negotiated blocks, and EFP/EFR.¹ Eris Swap figures are indexed to SOFR and BSBY.
  • Eris SOFR Swap futures replicate the amounts and timing of all cash flows of the equivalent fixed versus floating, SOFR-indexed swap across 11 tenors ranging from one year to 30 year.
  • Eris BSBY Swap futures allows long position holders to receive a pre-set, semi-annual fixed rate and pay a quarterly floating rate indexed to the 3-month BSBY Index across 1-year, 2 -year, 3-year, 4-year, 5-year, 7-year, and 10-year tenors.

Cash Treasury trading
BrokerTec CLOB, Stream, and RV Curve

• CME Group’s BrokerTec marketplace supports the cash trading of approximately $700B notional value of fixed income daily across multiple platforms:
  • BrokerTec’s CLOB offers the world’s most liquid electronic fixed income order book with a deep participant base.
  • BrokerTec’s Stream offers all the benefits of relationship-based trading via BrokerTec’s trusted and fully regulated markets.
  • BrokerTec RV Curve creates a single market to trade U.S. Treasury benchmark spreads, bringing the efficiency of implied orders from our futures inter-commodity spreads to cash bonds for the first time.

Short- and long-term futures and options products

SOFR futures and options on SOFR futures

• CME Group Three-Month SOFR futures and options offer direct exposure to the Secured Overnight Financing Rate published by the New York Federal Reserve and are the primary liquidity tool for hedging short-term interest rate risk for many institutional market participants. The quarterly cadence of these products aligns the mark-to-market accounting procedures associated with futures and options products with the accrual accounting procedures associated with AFS and HTM securities.

U.S. Treasury futures and options

• CME Group Treasury futures and options are available on the 2-year, 3-year, 5-year, 10-year, 20-year, and 30-year tenors and offer standardized contracts on U.S. government notes or bonds that offer a wide variety of strategies for market participants looking to hedge interest rate market exposure. This market is highly liquid and offers excellent operational efficiencies.

BSBY futures

• Three-Month BSBY Futures, based on the BSBY Index, offer exposure to a forward-looking, credit-sensitive reference rate that tracks the U.S. wholesale unsecured funding market. These futures trade alongside SOFR and Fed Funds futures to offer spread training opportunities and margin offsets. Given that the construction of these futures is based off of bank liabilities, BSBY futures provide tools for liability hedges.

TBA futures

• TBA futures allow for direct exposure to the mortgage market at a variety of coupon rates (currently 2.0%, 2.5%, 3%, 3.5%, 4%, 4.5%, 5%, 5.5%, 6.0%, and 6.5%). Unlike other interest rate products, TBA futures capture the optionality and spread component inherent in mortgage securities. In addition, while the production of new MBS has slowed at these higher interest rate levels, it is likely that older production MBS hits the market when the FDIC sells approximately $115B worth of MBS and other mortgage securities from its receivership. For reference, total MBS issuance in February 2023 was $65B.

Benchmark index products

CME Term SOFR

• BMR compliant, aligned with the IOSCO principles, and ready to use in cash market products, CME Term SOFR Reference Rates provide an indicative, forward-looking measurement of SOFR rates, based on market expectations implied from leading derivatives market. Market participants who need to hedge underlying exposure to short-term rates should consider upgrading their licensing agreement to include derivative use.

CVOL

• The CME Group Volatility Index uses data from liquid options contracts traded on CME Group exchanges to produce the market’s expectation of 30-day forward risk. This robust construction and ease of use allows market participants extremely easy monitoring of volatility conditions across a range of important and liquid assets. These indices are extremely valuable to market and credit risk departments that continue to seek better methods and data to monitor dynamic changes to the markets.

BrokerTec U.S. Treasury benchmarks

• BrokerTec’s U.S. Treasury benchmarks use a deep liquidity pool of transactions to create volume-weighted benchmarks for 2-, 3-, 5-, 7-, 10-, 20-, and 30- year on-the-run U.S. Treasury bonds. Calculations are made four times daily and coincide with key rate times.

Banks have long been one of the most significant clients for CME Group, and their importance has grown with the financial needs of their local and global customers. In addition, banks are a critical component in the stability and security of the U.S. financial system. CME Group has worked closely with banks over the last many decades to help them best hedge their portfolios.

1. For more information, please see Rule 526 and Rule 538.