The Sovy universe
The CME’s Sovy contract was launched in May 2011, and looked at first glance like a sure-fire winner. While Eurex’s BTP contract offers exposure to the entire yield curve of one non-AAA government and the absolute-risk on the short- mid- or long-term segment, the Sovy futures offer relative exposure to just the 10-year spread, but across several governments. The contracts offer outright exposure to twelve interest-rate spreads on one platform and one clearinghouse, and they are priced in a way that is simple and direct.
The contract is four months old and has yet to gain much liquidity. The exchange attributes this to the summer’s epic volatility in Eurozone government bond markets.
"Because of the novelty of this contract mechanism, we decided it would be a good idea to give our market makers the opportunity to put up prices and become accustomed to it in the knowledge that customer flow will materialize later," says Fred Sturm, director of financial research and product development at CME Group.
Many traders, however, said the contract was too novel. Several said they were leery of the cash settlement.
"Yield spreads are cash settled, and that’s a problem because there’s no official fixing in the European government bond market," says one. "Most of the volume is over-the-counter, so there is no transparency, so people don’t trust them."
Mike Kamradt, director of interest rate products at CME Group, says the settlement mechanism is as transparent as any other because it’s based on the median price of bonds in the market. He believes traders will take to it as they come to understand the product.
"What’s in the reference bond baskets — and how the reference bond baskets are determined — is completely transparent to everybody," Kamradt says. "For example, to be a reference bond, an issue has to have at least two billion outstanding, it has to have between eight-10 years of remaining term to maturity, etc."
The exchange obtains all reference bond prices from Interactive Data, the designated third-party valuation service, and the product brochure describes a detailed settlement process.
"On the Sovy futures contract’s last trading day, Interactive Data furnishes to the exchange a valuation for each reference bond, for standard settlement (T+1 for US and UK, T+3 for all EU), based on government securities market activity between 3:00 and 3:02 p.m. London time," the exchange says. "For each reference bond, the exchange converts price to yield. For each sovereignty, the exchange then computes the median of reference bond yields. For instance, the representative yield for UK is the median of yields to maturity on all gilts that are admissible as reference bonds, while the representative yield for Germany is the median of yields on all Bunds that are eligible to stand as reference bonds. The exchange uses these median yield values to calculate each Sovy contract’s final settlement price."