The Montreal Exchange, Canada’s derivatives market owned and operated by TMX Group, is responding to increasing demand for interest rate hedging tools, structural changes linked to the transition away from Libor and a trend in its domestic market to explore the longer end of the curve with changes to its established interest rate product suite.

Speaking to Global Investor, Robert Catani, Head of Institutional Sales and Trading Fixed Income & Derivatives at TMX, said Canada is an interesting market for international traders in its own right, but it also benefits from its relationship with its powerful neighbour.

“As a G7 country, Canada has one of the strongest economies in the world while the proximity to the US market is favourable. Our interest rate market, while it does not mimic the US per se, has a common trading element that makes Canada unique. Canada-US spreads, whether they be at the front end spreads or out in the five or ten year part of the yield curve, are constantly being traded by international investors, not only in North America but across the globe.”

Catani said the US and Canadian economies are intertwined but their interest rate markets are different in that Canada’s is not as liquid at the longer end of the curve.

“If you look at the US, the 30-year is a vibrant market and the 30-year mortgage market spread is based on 30-year rates. The Canadian mortgage market, however, is predominantly five years. Most people in Canada, if they have a mortgage, will either fix for five years or they will go for a one-to-three or four-year floating rate.

“The biggest dynamic in the Canadian yield curve is that all this business in the mortgage market is conducted in the one-to-five year term and that is the most active part of the Canadian yield curve.

“At the long end, whereas the US has this vibrant long-end based on 30-year rates, Canada does not so our supply in the 30-year part of the yield curve is somewhat limited where the only issuers are provincial governments, the Government of Canada and certain corporations,” he said.

Catani believes the Canadian market has not historically provided the fixed income products to satisfy the specific requirements of pension plans or fund managers trying to match their longer term liabilities.

“The result is that the tens/ thirties curve in Canada has historically been tighter than the tens/ thirties curve in the US, and that is something that international investors need to be aware of. It has been that way for decades and I do not see that changing.”

Yet, Catani said there are some recent green shoots at the longer end of the curve, partly as a result of the economic pressures of the Covid-19 pandemic.

“For the first time, the issuance at the long-end by the Canadian government has exploded because of the pandemic spending by Canada and other countries so we finally have more securities that are available on the government side at the long-end of the Canadian yield curve.”

In November 2021, the Montreal Exchange launched a new market-making program on its 30-year Government of Canada Bond Futures (LGB™) backed by National Bank Financial and Desjardins Securities. The plan was to increase the number of liquid points on the Canadian listed yield curve and, thereby, enable hedging with longer maturity instruments.

Trading volumes in the LGB remain relatively light at fewer than 10,000 lots a month but the exchange has high hopes for this product, which complements its more established contracts.

“Prior to a couple of years ago, international investors had the ability to trade the BAX™, which is the short part of the Canada curve like the US Eurodollar futures, and the Ten-Year Government of Canada Bond Futures or CGB™, our premiere product. About four years ago, we launched the Five-year Government of Canada Bond Futures or CGF™ contract which is now a big part of the Canadian fixed income futures market that trades vibrantly and is very liquid.

“This gave investors another part of the yield curve they could attack and it has been terrific for the Canadian market as there is so much more hedging to be done at five years domestically.”

The Montreal Exchange CGB future is the group’s most popular interest rate future, trading just over 2.8 million lots in March 2022, according to the exchange.

The Three-month Canadian Bankers Acceptance (BAX) is the next most-traded product at 1.9 million lots in March 2022 and the CGF is the group’s third most liquid fixed income contract, trading just over 960,000 lots in March 2022, an increase of 47% on the same month last year.

Catani continued: “Following that success, we launched just over one year ago the CGZ™, which is a Two-year Government of Canada Bond Futures, again addressing a big domestic market need for low cost products that you can use to hedge. So we now have vibrant trading in the two-year, five-year and 10-year, giving international investors the opportunity to trade Canada without having various relationships with dealers.”

The Montreal Exchange Two-year Government of Canada Bond Futures (CGZ) traded over 321,000 lots in March 2022, up 86% from the same month last year.

The exchange, like many of its G7 peers, is also helping clients manage their transition away from discredited Libor-based lending rates to new, risk-free rates (RFR). The Canadian RFR is the Canadian Overnight Repo Rate Average (CORRA).

Catani said: “As in the US with  the transition to SOFR futures and the UK with the transition to SONIA futures, we are beginning our transition now and we are relaunching CORRA futures in May. We expect that market to be pretty vibrant in 2023.”

“The RFR gives people around the world the ability to trade a true rate based on data from the Bank of Canada and is not, therefore, open to manipulation, and has no credit spread in it. The ability to cut-out the credit component on the risk-free rate is significant and gives everyone the ability to trade the front end based on Canadian monetary policy and not on credit risk.”

The US has mandated the cessation of Libor for new contracts next year, but firms are voluntarily moving across to US RFR ahead of that deadline. CME Group, the largest US rates market, said in late April that its SOFR futures book surpassed its legacy Eurodollar futures market for the first time on April 19.

Catani concluded: “Given the US is quickening its adoption of SOFR futures and moving away from Libor, I think we are going to see that whole ecosystem of cross-currency swaps trading create a more vibrant RFR market in both Canada and the US.

"I think we will also see all the swap derivatives transactions in Canada migrate to hedging with CORRA futures as early as the middle of 2023.”

International investors can capitalize on Canadian frictionless futures trading and portfolio diversification opportunities almost 24 hours a day.

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