Treasury futures have garnered significant attention in recent industry and media reports. This paper discusses the principal driving factors that contribute to the ongoing growth of Treasury futures and the vital risk management function they perform in today’s economy and the financial system. These factors are inflation, interest rates related to U.S. monetary policy, federal deficits and debt, investors’ need for duration, institutional market participants’ focus on efficiencies as bank balance sheets have faced constraints from the Basel III supplementary leverage ratio, and the optimal delivery basket-based design of the Treasury futures that in the last four decades has increasingly demonstrated its value proposition.
Today’s market is characterized by some of the highest interest rates seen in over two decades. In the ongoing battle against inflation, the Federal Reserve has tightened its monetary policy by lifting its target Fed Funds range from 0%-0.25% in early 2022 to 5.25%-5.5% by August 2023. The Fed’s balance sheet has come down from $9 trillion at its peak in 2022 to its current $8 trillion as the Fed is allowing its Treasury (UST) and Mortgage-Backed Securities (MBS) to mature without reinvestment according to a specified schedule. Simultaneously, the U.S. government faces an annual deficit of $1.5 trillion, or more for the foreseeable future, requiring increased borrowing through Treasury bills, notes, and bonds. Consequently, the Treasury market is experiencing higher yields and increased volatility.
To navigate these turbulent waters and additional supply of Treasury duration, market participants are increasingly turning to the efficiency and deep liquidity of CME Group Treasury futures. Record highs were reached just before Labor Day 2023 in risk transfer, open positions, and participation as measured respectively by average daily volume, open interest, and CFTC’s reported large open interest holders. Furthermore, a striking comparison emerges when examining futures trading volumes published by CME Group and cash volumes published by FINRA’s reporting system, TRACE. Trading in Treasury futures outpaces cash Treasuries across all platforms combined, including all dealer-to-dealer and dealer-to-client activity in cash Treasury securities as reported to TRACE by broker-dealers.
Participant types and use cases
The applications of Treasury futures are diverse, encompassing hedging by market makers in cash Treasury securities, duration risk management by asset managers, algorithmic market-making by proprietary trading firms, and view-taking by hedge funds. Treasury futures are also employed extensively in relative value trading such as yield curve, invoice spreads, and basis spreads. An invoice spread is a position in Treasury futures held against an offsetting matched maturity SOFR OIS swap. Treasury basis involves Treasury futures exposure held against an offsetting position in the cheapest-to-deliver cash Treasury security (CTD). More on CTD later. The Treasury basis trade plays a vital role in aligning efficient pricing between futures and cash securities.
Treasury futures stand out as the preferred risk management instruments due to their efficiency, consistent liquidity, and centralized and anonymous trading. Treasury futures are traded by a broad spectrum of market players, including global banks, asset managers, hedge funds, central banks, sovereign wealth funds, pension, insurance, and mortgage companies, as well as proprietary trading firms. Proprietary trading firms employ algorithmic trading to make markets within the Treasury futures market. Asset managers acquire duration through Treasury futures for capital efficiencies and liquidity. Hedge funds over the last four decades have continued to provide vital price discovery, liquidity, and alignment with the cash market by buying cash when it cheapens and hedging with futures. The short open interest of Treasury futures held by leveraged accounts has continued to increase in 2023 as reported by CFTC’s Commitment of Traders’ (COT) Report. A number of global bank strategists have covered the perceived growth in the Treasury basis (long position in cash hedged by a short position in futures), noting the important ecosystem function provided by this trade and continued adherence to appropriate risk management standards. It is also important to realize that the growth in short open interest in Treasury futures has been less than the increase in the U.S. marketable debt, see table below.
|Measure (all values in $millions||7/30/2019||2/25/2020||9/19/2023|
|Leveraged Money Short Positions||$921,285||$857,762||$1,047,839|
|Leveraged Money Net Short (Short-Long)||$608,754||$434,177||$696,613|
|U.S. Marketable Debt||$15,968,140||$16,918,525||$25,477,563|
|Shorts as % of Marketable Debt||5.8%||5.1%||4.1%|
|Net Shorts as % of Marketable Debt||3.8%||2.6%||2.7%|
The delivery basket-based design of Treasury futures: A key to success
Treasury futures obligate a buyer (long position holder) to accept delivery from a seller (short position holder) of a specified quantity of notes or bonds, constituting the delivery basket for the contract. This concept, introduced in 1977 with the launch of the Treasury Bond futures contract, has evolved to become one of the most vital fixed-income risk management instruments, witnessing exponential growth in open interest. This growth has been spurred by institutional participants’ increased focus on efficiencies and minimizing total cost of trading, with a backdrop of increasing demand for duration by liability driven investors (LDIs) and asset managers amid a simultaneous rise in U.S. marketable debt from $3.5 trillion in 2003 to $25 trillion in 2023. The value proposition of Treasury futures with regards to efficiencies and liquidity has shined in particular over the last decade, as bank balance sheets have been impacted by the ongoing implementation of Basel III. The hunt for efficiencies along with rising risk management needs in the Treasury market has been supported by Treasury futures. Market participants have demonstrated confidence in the delivery basket-based design of Treasury futures to maintain tight linkages with the underlying cash market while enabling the necessary and dramatic growth.
The key to understanding the success of the delivery basket design is to ask what contract structure could support the growth of open interest and trading to match the size of the Treasury market while meeting market participants’ needs for optimal price transparency and liquidity. Cash settlement is impractical for the very large and benchmark Treasury futures market because it necessitates a benchmark index whose daily calculation is supported by transactions similar in size as the futures market, where open interest currently is about $2.3 trillion. As another alternative, a futures contract that delivers into a single Treasury security would be inherently limited in size, preventing it from effectively serving the broader market's evolving needs. In contrast, the delivery basket-based design allows for a wide range of securities to be delivered, enabling growth of the contract by essentially aggregating liquidity across multiple cash Treasury securities.
Indeed, sophisticated market participants fully appreciate the ingenuity of the delivery basket design. Client feedback has consistently reflected demand for continued liquidity in Treasury futures. Both the Ultra 10 Treasury futures launched in January 2016 and the Ultra Bond Treasury futures launched in January 2010 were created in response to client demand. Supported and valued by our market participants, the success of Ultra 10 and Ultra Bond Futures contracts speaks for itself, as shown by the table below.
|Symbol||Futures Product||Delivery Basket Maturity Range||Basket Size ($ billions)*||OI ($ billions)||OI (contracts)|
|TU (ZT)||2-Yr||1y 9m to 2 years||$547||$772||3,857,547|
|FV (ZF)||5-Yr||4y 2m to 5 years||$482||$552||5,515,314|
|TY (ZN)||10-Yr||6y 6m to 7 years 9m||$914||$473||4,729,067|
|UXY (TN)||Ultra 10-Yr||9y 5m to 10 years||$271||$185||1,848,163|
|US (ZB)||T-Bond||15 years to 25 years||$2,364||$138||1,377,491|
|WN (UB)||Ultra T-Bond||25 years to 30 years||$1,202||$154||1,535,390|
|* Current values based on September 2023 contract month and measured as of September 22, 2023.|
Source: CME Group
Timing and quality of delivery options
The purpose and intent of the deliverable design, as explained above, is to maintain a fast and tight linkage to the cash Treasury market, and not to serve as a mechanism for participants that actually intend to acquire bonds, which is best enabled by the cash Treasury market itself. Our market participants agree. Typically more than 98% of positions in Treasury futures are rolled forward by closing the expiring contract and establishing a position in the next quarterly contract.
Within this framework, short position holders have the flexibility to choose which security to deliver from a set of deliverable notes and bonds (constituents of the delivery basket) on any business day during a delivery month. For operational details and more information on timing, see CME Group’s paper, The Treasury Futures Delivery Process. The choices involved in timing and selection of the security to deliver awards the short position holder Timing of Delivery and Quality of Delivery options. These options, much like the less than 2% physical deliveries, are the consequence and not the intent of the powerful delivery basket-based design. The Timing and Quality of Delivery options are explained in significant detail in the CME Group paper, Treasury Futures Delivery Options, Basis Spreads, and Delivery Tails. Briefly, the Timing of Delivery option essentially captures the fact that the short position holder will make delivery on a day within the permissible window that optimizes carry income on the security being delivered. Quality of Delivery involves choosing the security to deliver that is economically most advantageous to deliver. The Quality of Delivery option is also called the cheapest-to-deliver option, or CTD switch option.
Cheapest-to-deliver (CTD) and potential switches
The concept of the "cheapest to deliver" (CTD) is a key element of Treasury futures. It arises from the conversion of futures prices to invoice prices for the delivered security, facilitated by a notional coupon of 6%. This notional coupon helps calculate conversion factors to standardize across the eligible notes and bonds in the delivery basket, which have a range of maturities and coupons. The conversion factor depends on coupon and maturity and is defined as the price of $1 of the Treasury note or bond, discounted with a yield to maturity of 6%. With the conversion factor and the accrued interest unique to each eligible security in the delivery basket, the final invoice price for the delivered security is as follows:
Delivery Invoice Price = Futures Settlement Price * Conversion Factor + Accrued Interest
Traders identify the CTD security based on price, not yield, as the bond or note with the lowest purchase price relative to the invoice price, should they choose not to roll the contract forward. The futures price tracks the price of the CTD, adjusted by the conversion factor.
The level and shape of the Treasury yield curve along with the mathematics of the conversion factor system favor the highest duration (i.e., low-coupon, long-maturity) security to emerge as CTD when yields are above 6%, and lowest duration (i.e., high-coupon, short-maturity) security to become the CTD when yields are below 6%. Ultimately, the CTD is based on achieving the highest invoice price as noted above. For further details on CTD invoice price calculations and a related concept of implied repo rate, see the CME Group paper, Understanding Treasury Futures.
As the curve reshapes and yields move up or down, an occasional change in CTD - i.e., a CTD switch - may start to become probable even if the yield levels have not crossed the 6% notional coupon threshold. This is because both the shape and the level of the yield curve interact with the security’s coupon and maturity to determine its duration and, more importantly, the invoice price calculation outlined above.
In recent months, yields have increased and the curve has steepened, e.g., 10-year yields have increased from 3.3% in April 2023 to 4.6% in September 2023. This trend potentially brings a CTD switch into play, currently notable in the Treasury Bond futures contract (Bloomberg code: US and Globex code: ZB). Some portfolio rebalancing would be required as the duration of the futures contract changes with the likelihood of the CTD switch. It is important to realize that the futures market prices and DV01 (dollar value of a basis point) risk measurement incorporate the probability of the switch at a given time. Institutional participants typically keep their portfolios balanced with respect to market price and risk parameters, helping to keep CTD dynamics fairly smooth. And, it is rare for CTD switches to come into play. In addition, as a comparison, all cash Treasury securities become shorter over time and require active management to maintain the necessary duration of hedge exposure. Absent a CTD switch, Treasury futures maintain their maturity and risk characteristics throughout the life of the contract month, with duration maintained via the quarterly roll period. This advantageous feature is a key contributing factor in the popularity of Treasury futures for use by liability driven investors (LDIs) and asset managers.
In today’s environment of rising yields and increasing supply of duration (marketable debt), relative value trading strategies - including Treasury basis, invoice spreads, and curve trades - play a vital role in establishing necessary linkage between futures and cash Treasury markets. These trade types provide price transparency and liquidity, ultimately helping the economy. Moreover, the market participants are highly familiar and adept with managing the price and risk dynamics of Treasury futures, as demonstrated by the resilience and growth of Treasury futures in the last 46 years. The highly liquid Treasury futures typically act as constant maturity duration instruments, as more than 98% of positions are rolled forward and less than 2% of the open interest goes into delivery.
The delivery basket-based design of Treasury futures maintains tight linkage with the cash Treasury market, enabling liquidity aggregation across a range of eligible securities. Numerous CME Group and industry tools and educational materials are used by the market participants to seamlessly manage the Treasury futures contract. This proven resilience to changes in market conditions has increasingly drawn traders to the efficiencies offered by the Treasury futures, invaluable risk management tools for investors to navigate the complexities of the modern financial landscape.
The enduring success of Treasury futures, particularly exemplified by their dramatic growth in the last decade, lies in the efficiencies and liquidity they offer to meet the evolving needs of clients for duration, risk management, and hedging. The performance statistics for 2023 underline the significance of Treasury futures in facilitating efficient risk transfer, with record average daily volumes of 5.4M contracts ($614B), participation at an all-time high of 1,833 large open interest holders (LOIH), and market positions with open interest reaching a record 19.8M contracts, equivalent to $2.4 trillion in contract size.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.