WASHINGTON - The Chicago Board of Trade has proposed a dramatic re-engineering of the municipal bond futures contract and underlying index and is asking market participants to comment on the proposals by April 30.
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The proposals -- which would include creating a new underlying index of up to 200 bonds instead of The Bond Buyer Index of 40 bonds, using a pricing service instead of brokers' brokers to price bonds in the index, and adopting new trading rules -- are designed to prevent manipulation of the index and make the contract a better hedging tool.
"Recent declines in volume and open interest indicate decreasing acceptance of the current CBOT municipal bond contract," the CBOT staff said in a paper that was posted Friday on The Bond Market Association's Web site. "Market participants have identified two factors that have contributed to the decline. The first is that BBI-40 may not be broadly representative of the market. The second is that the pricing mechanism may not be the most efficient for determining fair value."
The CBOT staff proposed creating a new underlying index for the contract that would contain between 100 and 200 AAA-rated tax-exempt bonds. The bonds would have to be from an issue of at least $250 million in par value. The earliest call dates on the bonds would have to be at least seven years from the date of the bonds' inclusion in the index.
The muni futures contract, which was introduced into the market by the CBOT in 1985, currently is linked to The Bond Buyer's Municipal Bond Index, which tracks the value of 40 actively traded municipal bonds. The index is a joint venture between The Bond Buyer and the CBOT. The CBOT pays The Bond Buyer a fee for managing and compiling the index and also pays brokers' brokers for pricing the bonds in the index.
The bonds in the index currently are priced twice a day by five brokers' brokers -- Butler, Larsen, Pierce & Co., Hartfield, Titus & Donnelly, R.W. Smith & Associates, Inc. Chapdelaine & Co., and J.J. Kenny Drake, Inc. The prices are based on actual trades when possible. If there are no trades, the brokers' brokers take bids from broker-dealers. If there are no bids, they estimate the prices. The list of bonds in the index is revised twice a month, and bonds that are not trading much are replaced with more actively traded bonds.
In recent years, industry experts have alleged that some broker-dealer firms manipulate the index either by submitting unrealistic bids for bonds which are accepted by the brokers' brokers or by taking large positions in the bonds just before the trading period closes. Because the contract's value equals the index at the contract's expiration date, inflating prices in the index can inflate the contract's settlement price as well. The contract expires every three months and the value of the contract at its expiration date is determined by the value of the index.
The CBOT has proposed that a pricing service provide daily closing prices for the bonds in the index and also calculate the index closing price, based upon those prices. The index price would be calculated as if it were a bond with a 5% coupon and 10-year maturity with a yield that is equal to the simple arithmetic average yield of the bonds in the index. Yields would be calculated based on industry conventions.
The contract would settle for cash on the final trading day. In order to minimize the potential for abusive trading practices, index pricing procedures and trading rules would be altered for the final trading day. A call option exercisable by shorts would be introduced for the spot month. In addition, on settlement day, bonds whose overnight movement is greater than one standard deviation of the mean market move would be discarded for cash settlement calculation purposes. "This procedure would substantially reduce the likelihood of index distortion due to sudden outsized moves by a small number of bonds," the CBOT staff said in its paper.
The CBOT staff also proposes the board adopt an accountability rule that would allow the CBOT to request certain information, such as the nature of a trading position, the trading strategy, and details about hedging, for its administrative oversight of the markets. The rule would apply to everyone with a position in the contract, regardless of the size of their position.
"They certainly have made a concerted effort to improve the usefulness of the contract for the industry," said John Ramsay, vice president and senior regulatory counsel of The Bond Market Association. "These would be fairly significant changes from what they're doing now."
