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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

Transition to SOFR from Libor Starts Small

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May 22, 2018

SOFR futures draw major market makers but volume sparse so far

Breaking News - tickerAt the end of their second week of trading, the CME Group’s new SOFR futures contracts had attracted an impressive array of market makers to support the derivatives, but so far market participants’ interest in the contracts has been light.

The Federal Reserve Bank of New York began publishing April 2 the Secured Overnight Financing Rate (SOFR), which regulators are promoting at a replacement for Libor (see “Libor to SOFR Switch Will be Challenging”). The transition will be a major undertaking but ultimately could significantly benefit corporates’ cash management and funding efforts. The CME Group’s launch of one-month and three-month SOFR futures May 4 represents an early and important step toward market adoption of the SOFR benchmark. Despite the low trading and open-interest volume so far, there are signs of demand for the product.

“All signals indicate tremendous depth of interest in both new SOFR products,” said Agha Mirza, global head of interest-rate products at CME Group.

He noted that, so far, SOFR futures have been traded by 60 global participants, with daily trading volume averaging 1,450 contracts and open interest resting at 4,700 contracts. “The screen is showing tight markets—0.5 basis points wide, the minimum tick increment.”

Tight spreads typically reflect market demand for a product, and the more than 10 Wall Street firms that have stepped up to make markets in SOFR futures, including bulge bracket banks such J.P. Morgan, Citigroup, Goldman Sachs and Credit Suisse, are another positive sign.

“We’re seeing diverse participation across customer segments, especially considering we are in the very early stages following the initial launch of two brand new futures products,” Mr. Mirza said, adding that market participants are either looking to shed SOFR risk exposure or acquire it.

The transition to SOFR is anticipated to transpire over the next few years and will likely involve a period where market participants hold a mix of Libor-based and SOFR-based debt and derivative products. Wall Street firms are anticipated to step up to provide products to hedge basis risk between those exposures during the transition period, as well as to develop SOFR-based products, perhaps using tools such as SOFR futures, to replace term debt and derivative products now based on Libor.

The SOFR reference rate is calculated from three existing indices directly related to overnight Treasury repurchase agreements (repos), comprising $800 billion in transaction volume on average. The opaquer Libor is instead based on theoretical rates submitted by a group of banks.

SOFR’s transparency should benefit corporates on several fronts. For one, corporate treasury managing cash will be able to measure more accurately the returns on their short-term investments and whether they are competitive. The same should hold true for the quotes banks provide for floating-rate debt and derivative products.

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