The difference between the interest rate on three-month Treasury bills versus the three-month London Inter-Bank Offering Rate (LIBOR), is known as the TED spread.
The difference between the interest rate on three-month Treasury bills versus the three-month London Inter-Bank Offering Rate (LIBOR), is known as the TED spread. The term “TED” arises from the 90 day T-bills and 90 Eurodollar (ED) certificates of deposit. TED-based strategies can be viewed as credit spread trades, pitting highest quality government debt against slightly lower quality AA-rated inter-bank debt.
The TED spread is measured in basis points (bps) where 100 basis points = 1%. For example, if LIBOR is 4.50% and 3-month T-Bills are trading at 4.10%, the TED spread would be 40 bp. The historic range of the spread has hovered between 10 and 50 bps, except during financial panics or downturns.
Recalling our discussion of the Capital Asset Pricing Model (CAPM), the risk-free rate is used as the basis for finding an asset’s or portfolio’s risk-premium. Well, that risk-free rate is none other than the 3-month T-bill rate – the “T” in TED. LIBOR is by definition riskier, because it has more than zero risk that one of the counterparties to an inter-bank load will default. Therefore, when the TED spread increases, investors are more concerned about counterparty risk, and thus demand a higher LIBOR (or equivalently, a lower price on Eurodollar securities) to induce them to assume the perceived extra risk. Conversely, the TED spread decreases when credit conditions are considered benign.
TED is an inter-commodity spread - you can trade the TED spread by pairs-trading T-bills and Eurodollar CD’s, or more likely, the corresponding futures contracts. If a hedge fund manager feels that credit conditions are going to worsen, he goes long the TED spread by shorting ED futures and buying T-Bills futures. The reverse trade, a short spread, favors the optimistic point of view regarding credit conditions, causing the spread to decrease.
You can also trade so-called term TED spreads, which use longer-maturity (i.e. 6 month, 9 month, etc) securities.
During the financial meltdown of 2008, the TED spread hit a record 465 bps, presaging the collapse of the interbank lending markets. Only massive injections of liquidity from central banks avoided a complete cratering of the financial system. The tendency of such liquidity injections during times of financial crises tends to moderate the long-term volatility of the TED spread.
In our next blog, we’ll examine liquidity-based yield spreads.
Under the Federal Reserve’s Regulation T, a security can be loaned at a minimum of 100% of its value for a permissible purpose. The purposes are to cover shorts, assure settlements or to loan to another.
In earlier blogs, we explored how prime brokers lend securities. Today we’ll take a closer look at the U. S. regulations that control security lending.
Under the Federal Reserve’s Regulation T, a security can be loaned at a minimum of 100% of its value for a permissible purpose. The purposes are to cover shorts, assure settlements or to loan to another. It also details the allowable collateral for such trades. The regulation states:
“Without regard to the other provisions of this part, a creditor may borrow or lend securities for the purpose of making delivery of the securities in the case of short sales, failure to receive securities required to be delivered, or other similar situations. Each borrowing shall be secured by a deposit of one or more of the following: cash, securities issued or guaranteed by the United States or its agencies, negotiable bank certificates of deposit and banker’s acceptances issue by banking institutions in the United States and payable in the United States, or irrevocable letters of credit issued by a bank insured by the Federal Deposit Insurance Corporation or a foreign bank that has filed an agreement with the Board on Form FR T-2. Such deposit made with the lender of the securities shall have at all times a value at least equal to 100 percent of the market value of the securities borrowed, computed as of the close of the preceding business day.”
While the required margin is 100%, the standard collateral margin required per the Stock Loan Agreements is 102% for U.S. securities and 105% for non-US securities. This is the determined hedge required against market exposure due the market value being computed as of the preceding business day. Also, while in addition to cash collateral, the regulation allows for Letters of Credit, Certificates of Deposits, or securities as collateral on loans. The SEC will now allow, in addition to the US Treasury bills and notes, any obligations issued by the any agency or instrument of the U.S. including FNMA, FHLMC and certain other securities which are not backed by the full faith and credit of the U.S. government. Zero Coupon Bonds and Strips are not allowable collateral pursuant to this rule. The Fed does not object to cash collateral in the form of foreign currency if the currency is that of the security’s country of issuance. However, this is all at the discretion of the lenders, thus, allowable collateral is stated in the Loan Agreement.
This is a Security Exchange Commission (‘SEC’) Rule. The rule is applicable to registered broker dealers trading on behalf of customers. Audit confirmations from any brokers trading for customer accounts may be received with wording to the effect of “In accordance with Rule 15c3-3, please confirm the following loans to us”. Additionally, some of the requirements of this agreement correspond to some points made in the Securities Lending Agreement and may shed some light on the relevance.
This is part of the Customer Protection Rules of the Securities Exchange Act of 1934 and details provisions of the written Securities Lending Agreement. The written agreement must at a minimum meet the following requirements:
- In a separate schedule, include basis of compensation for any loan and the rights and liabilities of the parties as to the borrowed securities.
- Provide that the lender will receive a schedule of securities actually borrowed at the time of the borrowing of the securities.
- Specify that the broker/dealer:
- Provide collateral consisting exclusively of cash, US Treasury bills or notes or irrevocable letters of credit issued by a bank as defined in Section 3-(a) (6) (A)-(C) of the Securities Exchange Act, which fully secures the loan of securities. Notice that Regulation T expands on the list of allowable collateral.
- Must mark the loan to market daily. In the event that the market value of all outstanding securities loaned at the close of business exceeds 100% of the collateral held by the lender; the borrowing broker must provide additional collateral as described above to the lender by the end of the next business day. At the end of the day the total collateral held by the lender cannot be less than 100% of the market value of the loaned securities.
- Post a prominent notice that the provisions of the Securities Investor Protection Act of 1970 may not protect the lender with respect to the securities loan transaction. This means that the collateral held by the lender of the loaned securities may be their only source of satisfaction of obligation by the borrower if the borrower fails to return the securities loaned.