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CBOT Chairman Neubauer's Letter To Treasury On Re-Opening For 10-Year Notes

Date 18/06/2002

June 17, 2002

The Honorable Brian C. Roseboro
Assistant Secretary of Treasury for Financial Markets
U.S. Department of Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

Dear Secretary Roseboro:

Your May 1st statement on the Treasury Department's quarterly funding needs invited comments on the possible changes to the regular re-opening policy for 10-year notes. The Chicago Board of Trade (CBOT) appreciates the opportunity to give its views on this topic. We suggest that, much like the Treasury's recent change to its 5-year note re-opening policy, the Department should adopt a policy that favors new issuance of 10-year U.S. Treasury notes over re-openings of existing 10-year issues.

Although re-opened issues will trade at a tighter bid-ask spread relative to new issues, they generally come to market with higher interest costs than new issues, since they forego the liquidity premium normally associated with new issues. These direct supply costs are significant and more than offset the gains associated with tighter bid-ask spreads. In short, although they lead to enhanced liquidity in a particular security, re-openings make Treasury debt management more expensive, not less. Current empirical research on Treasury bill re-openings by Michael Flemming, an economist with the Federal Reserve Bank of New York, provides supportive evidence on this issue.

Re-openings by their nature concentrate risk exposure at fewer points on the yield curve. This exposure increases the potential costs of Treasury debt management. New issues would allow the Treasury to diversify its liability structure more broadly across the yield curve. Diversifying liabilities will help mitigate the costs to the Treasury of managing its debt management program.

The Bond Market Association's Treasury Borrowing Advisory Committee has stated that re-opened issues are generally considered to be less effective as hedging instruments during the second half of their term to maturity. This decrease in hedging effectiveness weakens the public benefits generated by a Treasury debt management program that is viewed to serve as the benchmark curve for pricing domestic and global interest rate products. A routine and predictable program of new issuance would bolster hedging effectiveness and the broad benefits of the Treasury security markets.

In closing, I would like to reiterate the views of the Chicago Board of Trade regarding Treasury bond issuance, which I have previously articulated to Secretary O'Neill. The U.S. presently holds a valuable franchise in the risk-free, 30-year part of the spectrum, highlighted by the fact that the German government increased its issuance of 30-year bonds following the Treasury Department's announcement last fall.

Re-issuance of the Treasury bond would enable the Treasury Department to better serve the public good by providing a pricing benchmark for longer-dated spread products. The Treasury bond's presence would enhance price discovery on the long end of the curve, thereby facilitating lower financing costs for institutional borrowers. Re-issuance of the Treasury bond also would enable the Treasury Department to manage its liability mix with greater flexibility across a broader maturity range, thereby lowering financing risks and ultimately borrowing costs. With long-term interest rates at historic lows, today's circumstances present an excellent opportunity for the Treasury, like corporate America and mortgage holders nationwide, to lock in lower financing rates for extended maturities.

In times of crisis, a well-functioning Treasury bond market is critical to the stability of U.S. financial markets, both as a means for investors to shift long-term interest rate exposure and as a reliable means for market participants to assess the value of other long-dated assets and liabilities that are less liquid and less creditworthy. It is widely recognized that in the absence of Treasury securities, the U.S. financial market would be a much riskier place.

Again, the Chicago Board of Trade appreciates the opportunity to share our comments on these matters. We would be pleased to discuss our comments further with you and your colleagues at your convenience.


Nickolas J. Neubauer