Five European banks and two proprietary futures firms have made markets in the new contract during the simulation phase. They are expected to support the contract when it goes live, though they have not yet signed up, said Brendan Bradley, global head of product strategy at Eurex.
The principal users of the new contract are expected to be those bond desks that trade Italian BTPs and other non-triple-A European government bonds. In the past, these dealers would have used German Bunds as a hedge but in the past two years this position has become exposed to considerable basis risk.
"We began looking at this product about a year ago. When the credit crunch happened, the spread widened between Italian government bonds and German bonds," said Bradley, who is based in Frankfurt and London.
Italian BTPs blew out to 160bp wider than German Bunds at the beginning of the year, rallied to 85bp wider by the beginning of May but are now 100bp wider once more.
Greek government bonds, 20bp wider than Bunds at the start of 2006 soared to 300bp wider at the height of the credit crunch and are now 180bp or so wider than Bunds.
Eurex officials originally contemplated the use of a contract based on a basket of lower tier European sovereign debt, but widely differing bond market conventions made this idea impractical. After some deliberation, Eurex decided that the contract should be based on the price of BTPs, the largest debtor nation in the eurozone.
"It was clear that Italian BTPs should be used as a proxy for the lower end of the credit spectrum," said Bradley.
The new contract will be used as a proxy for Greek, Spanish and perhaps Irish sovereign debt, while the Bund will remain the proxy for French and Dutch bonds, for example.
Pricing will be Eu0.20 per contract, or Eu0.30 per contract on an over the counter basis. The contract standard will be a notional long term debt instrument issued by Italy with an original maturity not longer than 16 years and a remaining term of 8-1/2 to 11 years and a 6% coupon.
The contract may also be attractive to euro swap dealers. Payers of fixed rate hedge the position by buying government bonds while receivers short the bond market, and in the past German Bunds have fulfilled this role adequately.
However, over the past two years swap rates have become more closely correlated with lower rated European sovereign debt. The new contract could appeal to swap dealers exposed to the basis risk, says Eurex.
The big test for any new futures contract is its liquidity. Many contracts that were good in theory have foundered when they were unable to attract sufficient open interest.
Dealers may prefer to accept basis risk rather than liquidity risk, and whether the new BTP contract can overcome this hurdle remains to be seen.
Its principal competition will be the well established and highly liquid Bund futures contract. The average daily volume in the Bund future is 680,000 contracts and open interest stands at 790,000 contracts.
Of course, Eurex owns the Bund futures contract so it is to some extent indifferent to the outcome of this clash.
"There was sufficient interest from the market to do this new contract, but it could be done without a huge cost to us as it is similar to the existing Bund contract," said Bradley.