USD Swaption volume Dec 2023

Dec highlight:

The most interesting USD swaption trade in Dec was the significant trading volume reported in the 10y20y point, amounting to $4.6mm in vega. This made Dec the second-highest month for 10y20y vega following only Aug, despite overall vega volume being muted in Dec. This spike in 10y20y activity follows the large 10y10y transactions that we highlighted in the Nov report, and we suspect it is driven by a continuation of the same theme, i.e., Bermudan callable bond position re-hedging.

Dec report:

As 2023 came to a close, both gamma and vega reported activity slowed down. On the gamma side, transactions totaling $900k of gamma were reported, down 7% from Nov. In vega, there was a total of $94mm of vega activity, flat to Nov. Both vega and gamma showed significant declines from the peak levels seen in Aug.

The vega heatmap highlights prominent trades in the 10y20y point, which was the third most actively traded point of the surface by vega after 10y10y and 1y10y. Notably, the reported trades at the 10y20y point amounted to $4.6mm in vega, almost double the monthly average of $2.6mm observed in the first eleven months of 2023.

This spike is likely caused by the rally in the long-end of the USD swap curve, where 10-year rates decreased by approximately 50bps over the course of Dec. As discussed in the Nov report, large moves in long-end USD swap rates impact the call probability of Bermudan callable bonds, which are some of the largest positions on many banks’ USD swaption books. The change in call probability is reflected by a change in risk representation on the books. For instance, if a position suddenly becomes very likely to be called tomorrow, it will no longer contribute to risk reports. Consequently, traders buy/sell swaptions in the market in order to keep their overall vega risk balanced.

Although 10y10y reported the highest vega for both Nov and Dec, we think 10y20y is the more interesting trade this month. The flurry of trades in 10y20y potentially signifies stress in the USD swaption market. The USD Bermudan callable trades typically have a final maturity of 30 years or longer, implying that the relevant vega risk points for these trades should also have cumulative maturities exceeding 30 years, such as 10y20y. However, these extremely long-dated vega points are relatively illiquid. Therefore, traders initially rebalance their risk using more liquid instruments like 10y10y and hold a spread position between 10y10y and 10y20y, hoping that the vol surface does not markedly change shape in the short-term. Traders may resort to hedging with the less liquid 10y20y point if their risks have changed by such a large amount that adding more to the 10y10y vs. 10y20y spread position would breach risk limits.

This seems to have played out over Nov and Dec. In Nov, 10y10y was the most active vega point by far, while 10y20y did not even rank among the top 20 active points (although 20y10y did appear at number 7). By Dec, 10y20y had become the third most active vega point, and other typically illiquid points like 5y30y, 15y20y, and 10y30y also appeared within the top 20. If traders are forced to transact on these illiquid points of the vol surface to keep within their risk limits, then we may see wild price swings as the amount of risk that needs to be replaced overwhelms the market.

Fortunately, long-end USD swap rates have reversed some of the rally since the end of Dec, so the pressure on the market should also decrease but it’s a development that we’re watching closely.