There is a price cap in the market to borrow bonds
Price controls, including price caps, can lead to shortages. Images of cars in long lines at gas stations during Nixon-era price controls illustrate a classic case where a cap below market value was in place and shortages followed. But sometimes price caps exist for reasons other than direct regulation. Using a sample that covers more than 1 million trades, we find that the market for borrowing bonds in Canada also has a price cap: traders are willing to pay no more than the overnight interest rate to borrow a bond. The presence of this cap suggests that the probability of a shortage increases when interest rates are very low.
Shortages could have significant consequences because professional bond managers rely on a liquid market to reduce transaction costs and control interest rate risk. Just as businesses borrow money to meet obligations that arise from their activities, bond managers borrow bonds to meet settlement obligations that arise from selling bonds. Fontaine, Garriott and Gray (2016) and Garriott and Gray (2016) provide more details.
The effects of a price cap on bond borrowing are less visible than a cap on gas prices. But for the large numbers of Canadians that are clients of mutual funds, pension plans and insurance companies, the presence of this price cap could mean higher costs and higher risks when using bonds to invest their retirement savings. These risks can be especially serious if the overnight rate becomes very low in Canada (which is what Fontaine, Hately and Walton  argue).
There is no rule or agreement that explicitly caps the price to borrow a bond. Instead, a settlement convention in fixed-income markets limits the willingness of traders to borrow bonds and effectively caps prices in these transactions. One question, then, is whether modifying the settlement convention can eliminate the cap and enhance this market’s functioning. Currently, the cap limits the ability of market prices to bring together borrowers and lenders, increasing the risk of shortages. Hence, one potential benefit of modifying or eliminating the cap could be to raise the ability of asset managers and other bond holders to hedge interest rate risk and manage liquidity risk for Canadians.
The price cap is the overnight interest rate
To understand how a settlement convention leads to the price cap, it’s important to look at how sales of bonds are settled. The exchange of bonds and cash following transactions in the spot market is called “settlement.” Settlement does not happen immediately, but only after a fixed period, usually one or two business days.
But what if a bond seller does not deliver the bond to the buyer on the settlement date? This happens routinely and is termed a “fail to deliver” (Fontaine, Hately and Walton 2017). Until the seller delivers the bond to the buyer, no cash payment is received, and the seller bears an opportunity cost. For each day that delivery is delayed, the seller forgoes the interest rate that could be earned from investing the proceeds of the bond sale in the money market for one day—the overnight rate.
Ordinarily, when the overnight rate is high, this cost of failing gives the seller an incentive to find the bond in the borrowing market and execute delivery promptly. The seller should be willing to pay as much as the overnight interest rate to borrow a bond, but not more. In other words, the overnight rate is the cap on the price for borrowing bonds.
This price cap can be seen in the data by comparing the costs of borrowing bonds with the overnight rate. We look at two markets where investors can borrow Government of Canada bonds: the repo and securities-lending markets. (See Garriott and Gray  and Johal, Roberts and Sim [forthcoming] for details on these markets.)
Chart 1 shows the maximum borrowing price for each month in each market alongside the overnight interest rate for 2006 to 2018 (repo data begin in 2008). The cap is easy to see in the chart. Of the roughly 700,000 repos observed in our sample, 88 trades exceeded the overnight interest rate by 2 basis points or less, and only 9 trades exceeded the overnight interest rate by more than 2 basis points, by an average of only 4 basis points higher than the overnight interest rate.
The price cap effectively restricts the range of borrowing prices, dropping to as low as 0.25 percentage points when the overnight rate is the lowest. It is reassuring that the cap is evident for essentially all trades. It tells us that we can safely ignore other potential costs of fails because they must be small. If other costs were large, the seller would be willing to pay above the cap to borrow bonds.
Chart 1: History of maximum bond borrowing prices
* Maximum borrowing price in the market in one month
† Maximum Canadian Overnight Repo Rate Average (CORRA) in one month
Sources: Bank of Canada, Canadian Depository for Securities and Markit
The price cap is most binding for scarcer bonds
The price cap depends on a bond’s scarcity in an economically natural way. A bond that is in low supply tends to be scarcer and to have a higher borrowing price, which in turn should be closer to (or more likely equal to) the cap.
The higher likelihood of the price cap binding for scarcer bonds can be seen in Chart 2. The chart reports the probability that a bond is borrowed at a price close to the price cap, where the probability is computed by controlling for bond characteristics (term to maturity, age, trading volume and outstanding amount). We do not include indicators of scarcity derived from prices, since these naturally predict that a higher borrowing price is more likely to approach the cap. We report the probability for bonds in median supply and bonds in low supply, as measured by outstanding amount, and for different levels of the overnight rate.
Chart 2 shows that a lower overnight rate increases the probability of a borrowing price hitting the cap. This is intuitive, since a lower overnight interest rate corresponds directly to a lower price cap. Moreover, the yellow line (bonds in median supply) is lower than the blue line (bonds in low supply), indicating that bonds in low supply are more affected by the price cap when the overnight rate is low. For bonds in low supply, the probability of the borrowing price hitting the cap can be substantial: around 9 per cent when interest rates are at 0.25 per cent.
Chart 2: Estimated probability of hitting the price cap
Sources: Bank of Canada, Canadian Depository of Securities, Markit and CanDeal
Borrowing prices would have been substantially higher without the cap
The price cap can bind borrowing prices significantly. Using Maddala’s (1983) method of estimating demand and supply for markets where a price cap exists, we estimate that prices would have been 17 to 33 basis points higher without the cap. How large are the estimated prices relative to the cap? Chart 3 shows the percentage difference between the capped prices and the estimated prices (as if there were no cap), averaged across trades, for different levels of the overnight interest rate. The difference was 71 per cent when the overnight interest rate was 0.25 per cent (the point on the left of the chart). The chart shows that the effect is weaker when interest rates are higher (the line is downward sloping).
Chart 3: Price differences after removing the price cap
Sources: Bank of Canada, Canadian Depository for Securities, Markit and CanDeal
Is it possible to raise the price cap by changing settlement conventions?
Some jurisdictions successfully raised this price cap. On May 1, 2009, the US Treasury Market Practices Group reformed the settlement convention in the market for US government bonds to introduce an explicit fail charge for failing to deliver (TMPG 2009). Traders now face an additional penalty of up to 3 per cent for failing to deliver (in annualized interest). Therefore, the price of borrowing bonds could rise above the overnight rate because the cost of settlement fails increased.
Chart 4 reports borrowing prices for selected US Treasury bonds in 2009. This shows that the US fail charge increased the price cap. As in Chart 1, the borrowing price did not materially exceed the overnight interest rate before the fail charge was implemented. After May 1, 2009, borrowing prices in repo and securities-lending markets sometimes rose well beyond the overnight interest rate, but not beyond the level of the new price cap (the overnight rate plus the 3 per cent penalty).
Chart 4: Borrowing prices before and after the fail charge was implemented in the United States
Notes: * Maximum borrowing price in the market in one day
Sources: Federal Reserve Bank of New York, Markit and ICAP
The US Treasury market is a case in point illustrating that the price cap derives from a settlement convention. The evidence we provide shows that the same convention introduces a price cap in Canada. One natural question is how costly or how difficult it would be to remove the price cap in Canada, and whether that would benefit bond issuers and bond investors by improving bond market functioning.
The presence of a cap in the bond borrowing market means hoarding can create excess demand and that rationing is needed to allocate limited supply, which is what the classic image of lines at gas stations illustrates. One potential benefit of raising this cap could be to eliminate rationing and improve the ability of Canadian investors to hedge interest rate risk or to manage liquidity risk across a wider range of conditions in the bond market. In addition, it could weaken the relationship observed by Fontaine, Pinnington and Walton (2017) between settlement fails and the level of the overnight rate.
More work is needed to answer these questions and is a part of the broader agenda assessing the functioning of core funding markets in Canada (Fontaine, Selody and Wilkins 2009).
- Fontaine, J.-S., C. Garriott and K. Gray. 2016. “Securities Financing and Bond Market Liquidity.” Bank of Canada Financial System Review (June): 39–45. Available at https://www.bankofcanada.ca/wp-content/uploads/2016/06/fsr-june2016-fontaine.pdf
- Fontaine, J.-S., J. Hately and A. Walton. 2017. “Repo Market Functioning When the Interest Rate Is Low or Negative.” Bank of Canada Staff Discussion Paper No. 2017-3. Available at https://www.bankofcanada.ca/2017/01/staff-discussion-paper-2017-3/
- Fontaine, J.-S., J. Pinnington and A. Walton. 2017. “What Drives Episodes of Settlement Fails in the Government of Canada Bond Market?” Bank of Canada Staff Working Paper No. 2017-54. Available at https://www.bankofcanada.ca/2017/12/staff-working-paper-2017-54/
- Fontaine, J.-S., J. Selody and C. Wilkins. 2009. “Improving the Resilience of Core Funding Markets.” Bank of Canada Financial System Review (December): 41–46. Available at https://www.bankofcanada.ca/wp-content/uploads/2012/01/fsr-1209-fontaine.pdf
- Garriott, C. and K. Gray. 2016. “Canadian Repo Market Ecology.” Bank of Canada Staff Discussion Paper No. 2016-8. Available at https://www.bankofcanada.ca/2016/03/staff-discussion-paper-2016-8/
- Johal, J., J. Roberts and J. Sim. Forthcoming. “Securities Lending Market Ecology.” Bank of Canada Staff Discussion Paper.
- Maddala, G. S. 1983. “Methods of Estimation for Models of Markets with Bounded Price Variation.” International Economic Review 24 (2): 361–378.
- Treasury Market Practices Group (TMPG). 2009. Claiming a Fails Charge for a Settlement Fail in U.S. Treasury Securities.
We thank Joshua Fernandes for research assistance and Corey Garriott for extremely helpful comments and suggestions.
Bank of Canada staff analytical notes are short articles that focus on topical issues relevant to the current economic and financial context, produced independently from the Bank’s Governing Council. This work may support or challenge prevailing policy orthodoxy. Therefore, the views expressed in this note are solely those of the authors and may differ from official Bank of Canada views. No responsibility for them should be attributed to the Bank.