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Derivatives

Aussie Mart Up In Arms Over Proposed Swap Benchmark

Market professionals in Australia are furious over the government's proposal to buy back its debt, fearing the damage it will do to the interest rate swaps market. At first sight proposing that swaps become the risk-free benchmark looks like a gift for the instruments, but market professionals warn that removing the underlying liquidity could damage the AUD2.6 billion (USD1.46 billion) swaps industry.

"This is a huge negative for the Australian fixed-income market," said Alistair Wait, head of fixed income at Deutsche Bank in Sydney. "Swaps rely on hedging duration exposure through trading bonds. If there's less liquidity in the debt markets, bid/offer spreads on swaps will widen," he added.

Industry professionals have until Dec. 6 to submit their reactions to the proposed changes. David Alexander, spokesman at the treasury in Sydney, did not return calls.

"The government bond market is a natural cornerstone--you can't remove the foundation without causing a significant impact on other markets," said Ken Farrow, ceo of the Australian Financial Markets Association in Sydney. "It all starts from the bond curve," added Wait. He continued that liquidity would dry up in the swap market without a risk-free rate. "Few people would play in outright swap positions."

"There's a clear divide between theorists and market practitioners on this issue," said AFMA's Farrow, explaining that industry professionals feel the proposal is unworkable and would drive away liquidity in the fixed-income market while the government insists on paying off its outstanding debt, which they believe would lower interest rates.

It is not just swaps that will be affected. "This has implications for bond futures, corporates--the whole market," said Matt Hunt, head of fixed-income trading at Macquarie Bank in Sydney.

Market professionals said if the treasury goes forward with the proposal the government bond market would likely be shut down in three to four years. One trader gave the proposal a 50% chance while another official said there is a higher probability the regulation will go through. The government would use budget surpluses and capital raised by selling its stake in Telestra to buy back its bonds. Australia has already halved its debt in recent years, from around AUD110 billion to AUD50 billion.

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