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Libor to SOFR Switch Will Be Challenging

Response to CME’s SOFR futures contracts may provide early signal.

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Capital Markets

SOFR and SONIA Futures Gain Steam

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July 20, 2018

Risk-free reference rate building blocks put in place ahead of schedule

financial system softwareAccelerating on the path to replacing interbank offering rates (IBORs), major clearinghouses have announced six months ahead of schedule their intention to clear swaps based on the new risk-free reference rates (RFR), an important step toward building the types of cash products corporates use. 

The swap news arrives as futures exchanges slowly build trading volume and open interest in 1- and 3-month, RFR-based based futures contracts.

RFR rates are billed as such because they are generated from thousands of transactions daily, removing the bank credit risk inherent in the IBORs that market observers view as in danger of potentially disappearing after 2021, when banks are no longer obligated to make rate submissions. The London Interbank Offered Rate (Libor) is the predominant IBOR used to price corporate debt and derivatives, as well as a host of other financial products such as mortgages. The US’s Libor replacement is the secured overnight finance rate (SOFR), and several other RFRs are being developed separately around the world.

Clearing house LCH announced clearing the first USD SOFR swaps July 18, and Credit Suisse, Goldman Sachs and JP Morgan were among the participants to clear swaps using the new rate.

“The transition to using SOFR is hugely significant both for the US and the global derivatives markets, as clearing SOFR swaps will be a key component in developing a liquid market for this product,” Thomas Pluta, co-head of global rates at JP Morgan, said in a statement.

LCH notes that it will support outright SOFR vs fixed swaps, and two basis products, SOFR vs. USD Libor and SOFR vs fed funds.

Meanwhile the Chicago Mercantile Exchange (CME) confirmed that it plans to offer clearing of similar swap products in September. LCH has cleared since 2009 some swaps based on the Sterling overnight index average (SONIA), the UK’s RFR that was reformed and relaunched as a Libor replacement benchmark in April, around the same time the Federal Reserve Bank of New York began calculating SOFR.

The CME, LCH and the Incontinental Exchange (ICE) have all launched futures based on new RFR benchmarks, and while trading volumes remain low—typical for newly launched futures contracts—they appear to be gradually growing.

“There’s very little trading activity compared to Libor-based products, but it’s moving in the right direction,” said Jose Vega, co-chief investment officer at South Street Securities. “From the exchanges’ perspective, as trading grows the market becomes more relevant to participants, and participants are impacted by it. Liquidity begets liquidity.”

“This morning there was a 1-year SOFR trade versus OIS trade that was executed in the market, which demonstrates the support for SOFR index in the marketplace,” Mr. Vega added.

The Alternative Reference Rates Committee (ARRC), which devised SOFR, reiterated at a July 12 roundtable sponsored by the Commodity Futures Trading Commission (CFTC) that building liquidity in futures and cleared swaps will be key to the creation of more sophisticated products, making RFR-based financial products more usable for corporates and other end users. Philip Whitehurst, head of capital, collateral and liquidity for LCH’s SwapClear, said swap clearing is arrive six months ahead of schedule.

A major challenge today is that the transactions generating RFRs settle overnight, so the borrower of an RFR-based loan will know the interest to be paid only when a given interest period expires. Loans priced on three-month LIBOR today, instead, allow borrowers to know at the start of each three-month term what their payment will be at the end, a feature favorable for managing cash flows. Liquid derivative markets will be important building blocks for banks seeking to develop loans or derivatives referencing different SOFR terms.

“To offer SOFR based loans and term products, the banks have to be confident they can manage any basis risk arising from offering those products. SOFR derivative markets will need to exist to help manage that risk,” said Eric Juzenas, director of global regulatory and regulatory policy for Chatham Financial.

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