Quick Takes:  Mechanics and definitions of cross currency basis futures
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Ali Curi: Hi everyone, and welcome to ION Market's Quick Takes. I'm Ali Curi. And every week, along with my guests, Chris Barnes and Mark Bell, we take a quick dive into the headlines on the Clarus blog. 

Let's get started. Hi Chris. Hi Mark. 

Chris Barnes: Hey Ali, how you doing? 

Mark Bell: Hey Ali. 

Ali Curi: Hello gentlemen. Welcome back to Quick Takes.

Chris, let's start with you. What's your Quick Take for this week? Which headline from the Clarus FT blog would you like to discuss? 

Chris Barnes: All right, today I'm going to fill the shoes of Captain Obvious. If there was ever a blog that Chris Barnes from Clarus was ever going to write, it was going to be called "Mechanics and definitions of cross currency basis futures."

For the long term readers of our blog, "Mechanics and definitions of Cross Currency Swaps" has for many, many, many years been in our top three blogs of readership every single year in terms of cumulative read in terms of new reads, it's always super well read. It's obviously the product that I used to trade heavily involved in market infrastructure, heavily involved in innovation, heavily involved in data. And lo and behold, at the end of last year, I think about November, December time in email, pops up into my inbox from CME announcing cross currency basis futures. And this is like a carrot on a stick for me. Immediately, like I drop everything, phones off. It's a darkened room. I'm like, "What the hell? How are you going to do a future on a Cross Currency Swap?"

This is super, super interesting. I held off and held off and researched it as much as possible because I think as anybody who's active in markets knows, if you talk to a basis trader about something new, their face just goes kind of funny and they're like, "Not sure about that." And they do that whole plumber thing of, "I think it'll cost you, you know?" Well, uh, not sure." I definitely had that reaction about eight weeks ago when I was first reading about this, but I was like, "Nope, I'm not going to jump in, this is a new concept, this is something new." Market has fundamentally changed since I traded it, traders love to moan, people love to moan about Cross Currency Swaps markets. It's difficult to get size done, it's difficult for transparency, etc. Let's just take a breath. Let's go through the calculations. Let's go through the contract design and let's see what the potential uses of this are.

So I think two things, you know, one is that the contract design has only recently been possible. I would say this is entirely thanks to the fact that CME have franchises.

In dollar rates, in Euro rates, €STR, and in Euro dollar FX futures as well. And so the contract users inputs from those three underlying futures markets to create an index. And that is the forward starting cross currency basis expressed in basis points, starting out of the next IMM date. What that gave me an opportunity to do is for approximately the millionth time explain on a blog exactly what cross currency basis is, which is always fun.

I particularly enjoyed this because when I was first introduced to it, when I was 22 years old, I was taught about it in terms of like a dollar cash amount. So I was shown the cash flows on a Cross Currency Swap. I was shown the cash flows on an FX forward. And I was shown that the physical dollar difference that our results as a result of trading those two things.

And forever since I've kind of associated, you know, the basis points of a cross currency basis swap as that like dollar physical amount. It feels like a check. It really does feel like that. When you're a young trader, it's really, really helpful to have these concepts like laid out and crystallized in front of you in terms of that's your P&L. That is real money. 

And yet, of course, when we talk about futures, we're not talking about a physically delivered amount of Euros, a physically delivered amount of dollars. What we're talking about is a financially settled product. And so I've really had to approach this concept of a future on basis swaps as kind of a complimentary product.

So as opposed to a product that's looking to come into the market and move trading away from OTC, or move trading away from FX forwards into a different product, how I'm thinking of this is far more as a complimentary product. I think it really adds transparency to where the basis is. It's fantastic to have that index.

The index is a lot more credible the more it trades. And I have spoken to a number of exchanges previously about how in a post LIBOR world, the cross currency basis is really the only expression that we have left of funding stresses. We don't have LIBOR versus OIS observable spreads. And so if there's banking stress, the best place to see that funding stress and the best place to see those short ends credit spreads blowing out is really in the cross currency basis. And so again, it's a great tool to actually begin to overlay a credit spread view. And so it's allowing you to bring back an element of that tail risk that you had when you were trading Euro dollars compared to now just trading risk-free rates. 

Equally, this is a long way in the future, but does it pave the way for options? Maybe. Still haven't necessarily met a natural seller of basis swap options, but let's see. And then I think really the most pivotal thing here is that the product looks and feels ideal for hedge funds. If exchanges can be successful in getting market makers to support this, hedge funds will love this product, I think, because it introduces multilateral netting. It reduces the credit line consumption. Hedge funds don't trade deliverable products anyway. They're all trading forward starting, which are never taken to delivery. So if there is enough interest from hedge funds in the short end of the curve, then I think there will be a clamor for them as like a preference as a cheaper product to trade.

How that fits in with the rest of the Cross Currency Swaps world in terms of funding your book, dealing with end users and what the exact purpose of a funding product is, whereas you're trading a financially settled version of it, I think is a complexity that hopefully we'll be able to see play out in real time and we'll start to see meaningfully traded volumes in this. Just final thing is important to note that it's collateralized in dollar cash. When you're looking to replicate a Cross Currency Swap, you've always got to consider what currency it's being collateralized in because that does introduce a second order pricing element as well. But fortunately, basis traders love that element of complexity, right?

So I think it's fascinating. It's not going to be the last blog you see on it, really salute CME for throwing their hat into the ring. Love the added transparency. I need to pass over to my colleague, Mark, cause I can't believe there's no one else who's quite as excited as me, but I doubt that Mark is jumping up and down as I was.

Mark Bell: Chris, certainly when I first heard about the title of the blog, I thought, "I wonder how long Chris has been waiting for it." So it's interesting to hear that you sort of a little bit apprehensive about what this was going to mean. We read about it eight weeks ago. A couple of quick questions. The first one really is on the CME and the volumes.

They've created this new index from three futures that they already offer. Does this reduce the volumes in these contracts? 

Chris Barnes: No. If volumes take off in the basis contract, that will, I imagine, be additive volumes for the underlying contracts, because I think a lot of the market makers will look to leg into different elements of it.

I think it's a really, really attractive product for a shorthand trader to trade with that mindset. 

Mark Bell: The second question really, leads on from this one, but we've spoken about Euro dollar, but there are lots of other currencies out there for which surely there must be some sort of opportunity. And I think really on, you spoke about how tight the basis spreads are on Euro dollar, but you think of someone on the short end of the curve, the Taiwan dollar, the basis is massive in the implied forward points.

Is this an opportunity for the CME to expand their franchise? They've got the Euro dollar contract, they've probably got the FX contract on some of these other currencies working with some of the more regional or local exchanges to be able to deliver these types of basis curves, which increase volumes overall for everyone, could be a win-win for everyone.

Chris Barnes: Depends if you really need basis contract for that, or whether you actually want to trade the outright domestic interest rate. As implied from the FX market, which of course is what Singapore traded for years and years and years. The one thing I would just caution and remind people as we've been through benchmark reform, it's exceptionally difficult to get people to change what they trade.

If Thai dollar basis is already a deep and liquid market, Sure, go for it. Launch a futures market that kind of replicates and compliments it. If you haven't already got a basis market there, trying to do it in futures space first, that feels like a bit of a leap to me. My kind of pragmatic take on this is that it needs to be viewed as a complimentary tool to the existing pools of liquidity out there. It's way, way too early to say that it's going to create brand new markets. 

Mark Bell: Thanks. It's certainly interesting. 

Chris Barnes: All right, Ali, that's probably going to be my favorite blog of the whole year, which is depressing to say in February, but there you go. 

Ali Curi: Well, thank you, Chris. And please share with us again the title of your blog post. 

Chris Barnes: That was "Mechanics and definitions of cross currency basis futures."

Ali Curi: Great. That works. Chris Barnes, Mark Bell, thank you both for sharing your Quick Takes. Let's do it again next week. 

Chris Barnes: Look forward to it, Ali. Thanks for having us. 

Mark Bell: Thanks, Ali. 

Ali Curi: And that's our episode for today. You can read more about these topics on the Clarus blog, and you can follow ION Markets on X and on LinkedIn. Thank you for joining us.