LO 51.6: Describe the characteristics of special spreads and explain the typical

LO 51.6: Describe the characteristics of special spreads and explain the typical behavior of US Treasury special spreads over an auction cycle.
The difference between the GC rate and the special rate for a particular security and term is called a special spread. Special spreads are important because in the United States, they are tied closely to the U.S. government Treasury bond auctions, and the level and volatility of the spread can be an important gauge of market sentiment.
In the United States, federal government bonds are sold at auction based on a predetermined, fixed schedule. The most recent issue is called the on-the-run (OTR) or current issue, while all other issues are called off-the-run (OFR). Current OTR issues tend to be the most liquid, with low bid-ask spreads, that can be liquidated quickly even in large sizes. This liquidity makes them desirable for both long positions and short positions. For example, a repo lender would favor these securities for short positions because the shorts could be covered quickly and at a relatively low cost. The popularity of OTR issues as special collateral in repo trades historically resulted in lower repo rates and wider special spreads.
Several observations can be made by looking at the special spreads of OTR Treasury securities (OTR special spreads) and the auction-driven pattern of special spreads. First, OTR special spreads can be volatile each day depending on the special collateral. Second, spreads can fluctuate over time. Third, and most important, OTR special spreads are generally narrower (smaller) immediately after an auction but wider before auctions. They are narrower after auctions due to the extra supply of a new OTR security, which depresses special spreads. Spreads widen before auctions due to the substitutability of the special collateral as shorts change to the new OTR security.
The influence of auctions can also be observed from the term structure of individual OTR issues based on term special spreads (the difference between term GC rates and term special rates). Term special spreads are expected to decline immediately following the issue of the new OTR security but increase closer to the dates of the new auctions.
S p e c i a l S p r e a d s a n d R a t e L e v e l s
Special spreads generally move within a band that is capped at the GC rate (implying a floor of 0% for the special rate). When a trader short sells the OTR Treasury security but fails to deliver on settlement, the trader would not receive cash from the sale and would also miss out on a days interest on the cash. To satisfy the settlement obligation to deliver the bond, the trader could borrow the bond in the overnight repo market and pay a special rate of 0% (essentially the trader provides free financing in exchange for receiving the desired bond). At any rate below 0%, no trader would borrower the bond. This puts both an effective lower bound and an effective cap of the special spread at the GC rate.
The special spread can also be tied to the penalty for failed trades. Until 2009, there was no penalty for failed trades. Flowever, in light of the financial crisis and trillions of dollars in failed OTR deliveries, regulators adopted a penalty rate for failed trades, equal to the greater of 3% minus the federal funds rate, or zero. This means that as the federal funds rate
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Topic 51 Cross Reference to GARP Assigned Reading – Tuckman and Serrat, Chapter 12
increases, the penalty falls, and when the federal funds rate declines to zero, the penalty rate reaches its maximum at 3%. As a result, the new upper limit for the special spread is the penalty rate.

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