Three U.S. exchanges will go head to head in a battle for market share in agency futures.

The idea of trading futures on the bonds issued by government agencies isn't new. The Chicago Board of Trade trumpeted the idea in the 1970s as a complement to its nascent Treasury futures, but market participants responded with a collective yawn.

In January, however, the idea was resurrected stunningly. Within a week of one another, the Cantor Exchange, the Chicago Mercantile Exchange and the CBOT announced that they were each planning to list contracts on five- and 10-year Fannie Mae and Freddie Mac non-callable securities.

Why the sudden turnabout? The major dislocations in the bond market earlier this year signaled that the time might be right for a new kind of government security contract. This magazine asked way back in 1997 what the CBOT would do when the issuance of Treasury bonds slowed with the first budget surplus in a generation ("Is the Treasury Bond Future in Trouble?” December 1997). In January, the question was answered, after the U.S. Treasury Department announced it planned an unusual "reverse auction,” in which it would buy back some $30 billion in 10-year-and-longer-dated debt. The news sent the bond markets roiling, temporarily inverting the U.S. Treasury yield curve as investors flocked to 30-year bonds while they were still available.

With budget surpluses predicted to continue into the foreseeable future, it appeared as though Treasury bonds and notes might soon become endangered species. Some bond market players voiced public support for Fannie Maes and Freddie Macs as benchmark instruments should Treasury securities continue their volatile trading or shrink in supply in the coming years.

The Merc was quick to pounce on the situation, announcing that trading of futures and options-on-futures on five- and 10-year agency securities would begin via open outcry on March 14, with after-hours trading on Globex to begin March 19. The Commodity Futures Trading Commission approved the contracts on February 28, so all systems are decidedly go. The Cantor Exchange applied for CFTC approval on February 8 to trade futures on five and 10-year agencies beginning March 25, but said in a statement it will begin trading immediately following CFTC approval. The CBOT plans to begin trading futures and options-on-futures on five- and 10-year agency securities on March 31. As of February 29, it hadn't released its contract specifications yet or applied to the CFTC for approval, but since it already trades Treasury futures it'll likely take advantage of the CFTC's new 10-day "fast track” approval procedure.

Meanwhile, Fannie Mae was busily preparing a full complement of fixed-income products, from three-month bills to 30-year bonds, in an effort to replicate the Treasury curve.

While all this was happening, however, things changed in the underlying markets. In early February, the Treasury Department modified its earlier statement about its buyback program. Rather than focusing on long-dated bonds, it said, it would use "the entirety of the yield curve.” The announcement immediately snapped the yield curve back to normal as investors dumped long bonds and yields shot up, removing all doubt that Treasuries would remain the benchmark at least for the near future.

Now what?

All three exchanges believe agency futures still present tremendous opportunities for bond market players, and each believes it has a leg up on the others. The Merc says holders of agency debt have traditionally used eurodollar futures as hedge vehicles, so moving over to the Merc's agency pit would be logical. "The strong price relationship between cash agency debt and eurodollar futures will ensure that the new contracts provide additional trading opportunities for end-users who can spread the new agency note contracts against eurodollar Packs and Bundles,” said Merc president and CEO Jim McNulty.

The Cantor Exchange, meanwhile, plans to list the futures right next to the underlying securities on its electronic trading system, offering players instant hedging. Since the futures market is new, and since the move from open outcry to electronic trading is a foregone conclusion, the Cantor Exchange believes it's in the best position. "For the first time, the agency market will have an effective hedging tool,” says Cantor Exchange cochairman Howard Lutnick. "This...combination of speed and liquidity is something that customers have been seeking for a long time.”

The CBOT is optimistic as well, since it's been trading Treasury futures for nearly 30 years. "The agency debt market is rapidly growing, with issuance exceeding that of the Treasury market in recent years,” says Patrick Catania, executive vice president for business development at the Merc. "The trading potential of agency debt contracts is strong.”

What will the future be for agencies? Only time will tell.