The true nature of the derivative contract on French debt

The multiplication of misinterpretations related to the launch of the derivative contract on French debt leads to an apolitical analysis produced by a market professional to avoid amalgam and populism: This is a simple and useful contract, which was traded in the past in another form...

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At the launch on Monday, April 16 of the futures contract on French government bonds on EUREX, we have heard many politicians linked this contract to the dictatorial power of financial markets and the stranglehold of finance on politics. Certainly most have the excuse of misunderstanding the purpose and functioning of financial markets, but also the lack of any real experience in the private sector that could refine their knowledge of constraints on the achievement of Gross operating profit objectives. However, they have no excuse when they misrepresent reality to citizens.


1. A (simple) and useful vanilla product

This financial product could not be simpler in understanding and has nothing to do with toxic structured products with leverage that we saw born a few years ago as securitization based on credit derivatives. It is a futures contract to hedge against adverse movements in interest rates on French government bonds with 7-10 years maturity.

It can also be quite useful to a French institutional investor that manages the savings of millions of people and anticipates for good or bad reasons (with no special speculative attacks) a rate increase in the long-term public French debt, he will then sell futures contracts expiring within 6 months equivalent for example to the position of the French treasury OAT he wants to hedge (there’s a technique to calculate "scientifically" the number of contracts negotiated by determining the correlation at a given time between the hedged item and the hedging instrument). So if at the end of six months, interest rates have actually mounted, then the futures contract will be decreased significantly and impairment losses on the portfolio French securities held will be offset by gains on futures contracts, therefore the profitability on the savings invested would have been protected. If by chance the rate declined and futures contracts rose, losses on contracts would be offset by a revaluation of the portfolio of bonds held.

You cannot dictate to futures contracts on financial instrument or any other derivative products not to be into a speculative open position. This is nonsense and absurdity
Mory Doré

Similarly, an investor who anticipates a sharp decline in interest rates in three months (thus higher price for futures contracts) on French government debt and knows that he will have important subscription programs on French government securities to set up, can then decide to purchase the number of futures contracts required. If the anticipation is realized, the shortfall on future investments in government securities at lower yields will be offset by gains on hedges negotiated when purchasing futures contracts. If expectations were proved wrong, the losses on hedges will be offset by investment with higher yields.

We now understand better the usefulness of such a product, but it is probably more profitable politically to display the hydra of speculation (we will see later what is really meant by speculation).

2. A concept that is not new...

You should know that this type of financial product existed on the Paris financial futures instruments exchange (the famous MATIF) between 1986 and the early 2000s under the name Notional Matif.

Have you then heard politicians decry this type of product at the time? Not of course because either they were not sure that such a practice existed, or they do not care too much in because there was no dividend election to get into considering themselves as the enemy of finance. They did not care too much about traders, rating agencies, derivatives products...

The notional contract in Franc from 1986 to 1999 fell into disuse in the early years of the euro for one simple reason. There was on the futures market of the Frankfurt Stock Exchange (OTB Deutsche Terminbtirse) a cousin contract, the Bund contract intended to cover portfolios of German state. In 1999, the Deutsche Bund contract has naturally been replaced by the Euro Bund contract. This then became the hedging reference for all government bonds in the euro zone given its high liquidity.

The effectiveness of hedging OAT French or even Italian BTP portfolios with BUND contracts was perfect as the behavior of the government bonds of these countries were almost perfectly correlated with German government bonds. Disconnection observed since 2010 in Italy and 2011 in France has deprived investors in Italian and French government securities of an efficient hedging instrument. Those who hedged for many months OAT portfolios through sales of BUND contracts could then lose both on the OATs hedged whose rate rose and the sales of BUND futures contracts whose prices rose with the decline of German rates.

It was technically and financially legitimate to recreate a futures contract on French government bonds consisting of a deposit of securities of 7 to 10 years properly correlated with the securities to hedge. Moreover, for a year now, there is a BTP futures contract on Italian government bonds. I have not heard at the time any sensational statements from Italian politicians claiming a conspiracy against the Public Italian debt. Just as the Bund and the BTP, the new futures contract on the French debt is traded on the Eurex (European Exchange). The futures market was born in 1998 from the merger of OTB and Zurich SOFFEX (Swiss Options and Financial Futures Exchange).

3. Speculation and regulation: Beware of amalgam

You cannot dictate to futures contracts on financial instrument or any other derivative products not to be into a speculative opened position. This is nonsense and absurdity. It is necessary to have speculators and arbitrageurs for investors to hedge their risks on financial markets.

Ces investisseurs transfèrent sur les Banques de financement et d’investissement les risques financiers qu’ils ne peuvent pas supporter d’un point de vue économique et réglementaire.
These investors transfer financial risks they cannot handle from an economic and regulatory point of view and to corporate and investment banks. Speculators, even if their purpose is short-term and is primarily about maximizing their P & L, they do create liquidity essential to the functioning of markets (banning speculation will suppress the existence of the market and therefore remove any hedging option for private economic agents). Arbitrageurs, in turn, play a role in regulating market prices and take advantage of valuation anomalies of certain assets (what you sell is overvalued and buy what is undervalued). There may be limits related to asset valuation models and this type of players often use massive leverage (less today because it is more expensive to fund) to make profits from these strategies. But overall, like the trading activity, this type of work is also part of the efficient functioning of markets.

It is certainly necessary to regulate but not confusing everything and especially preventing

  • Individual and institutional investors from growing peacefully their savings
  • Institutional investors and treasurers from hedging their risks in satisfactory economic conditions (high liquidity and transparent and competitive price of hedging instruments)

This does not question intelligent and non-productive regulations against. . We quote two lines of thought:
-We must reduce the destabilizing effect of certain assets price changes in the economy. This implies a development of IFRS, for example leaving aside the mark to market for certain types of financial instruments and certain types of financial market participants.
-We must also impose limits on the weight of structured illiquid assets with high leverage in certain portfolios (by penalizing in terms of capital consumed). And in this respect, the new debt futures contract is neither structured nor illiquid (it should even be the opposite) and is characterized by a normal leverage considering any classic derivative instrument.


In any case, we should not forget that many politicians who are so quick to put on trial financial markets today come to forget that they, regardless of their political persuasions, delegate their economic policies to these markets in the early 1980s in the Anglo-Saxon world and since the mid- 1980s in continental Europe. It was then the famous period of 3 D: Deregulation, disintermediation and deregulation.

At that time, the markets were adorned with all virtues: effective financing of the economy through disintermediation between the lender and the borrower; massive and effective funding of the public debt (as in France with the involvement of banks-SVT - primary dealers in the monthly Treasury securities auctions).

Then it is easy to condemn the alleged madness of today markets because, after all, why they are required to subscribe to the emission of treasury securities and prohibit from selling them when they feel, rightly or wrongly, that fiscal policies are not sufficiently rigorous and threaten the solvency of some states.

The disappearance of exchange rate risk with the creation of the euro has unfortunately led to a loosening of fiscal and budgetary discipline from countries with external deficits. The increase in foreign debt from deficit countries in the Euro zone was naturally facilitated by the disappearance of exchange rate risk and the funding of external deficits of some countries by surpluses in other countries. Until the markets have realized that some of these countries had entered into a solvency crisis and not a liquidity crisis. We then turned to the ECB to directly finance their debt or indirectly through LTRO which allowed banks from deficit countries to continue buying the sovereign debt of the country. However, the effects of LTRO fade quickly: for example, Spanish banks have now exhausted their central bank liquidity from LTRO which was used to buy Spanish sovereign debt and pay back those due in the year 2012.

Today, foreign exchange risk premiums therefore reappear despite still the single currency and the sovereign debt crisis in the euro area in the 2010s is now replacing the EMS currency crisis of the 1990s. We can no longer overcome the budgetary and fiscal discipline. And when 70% of your debt stock€ 1700 billion is held by non-resident investors, as is the case in France, you cannot ignore the demands of markets and rating agencies (unless you want to move towards a moratorium on any part of your debt, so a suicidal partial default).


There is nothing shocking to say and write that our country is living beyond its means (we hear some politicians whispering about that). This is obvious when we look at our deficit and debt ratios under our potential growth and our ability to increase the tax burden without further degradation of the economy (we are without doubt not quite far from the highest point of the Laffer curve from which any further increase in taxation discourages activity and thus lower tax revenues ... )

Growth without fiscal virtue is useless and fiscal discipline without growth as well

So the markets need economic growth if we want risky assets to perform: equities, high yield corporate bonds and investment grade, assets indexed to the performance of commodities. But they also need rigorous management of public funds to guarantee the assets backed on the creditworthiness of issuers: government bonds, bank bonds and to lesser extent corporate bonds.

The teaching is simple: growth without fiscal virtue is useless and fiscal discipline without growth as well. If the markets are convinced that politicians are able to create the conditions for economic growth in an environment where financial balances must be controlled and public funds rigorously managed, then any speculative attack will have no credibility and will be stillborn.

This means that we must distinguish between good and bad expenses, provided that the good expenses are profitable and promote growth. Which means a supply policy in countries with low growth potential (Southern Europe, France... ) or demand policy (as in Germany) if firms are sufficiently profitable, self-funded and the economy sufficiently competitive.

This is for the spending side. For the revenue side, we have to distinguish between good and bad taxes, good taxes are those that do not discourage growth (in the case of a supply policy, by taxing consumption and de-taxation of production factors likely to be relocated).

Mory Doré September 2012

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