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A Big Moment Arrives for SOFR

Evan Peterson, CME Group

AT A GLANCE

  • A long-awaited step for the transition to SOFR happened in October with more than $7.2 trillion notional shifting from the Fed Funds rate.
  • SOFR takes its place as “a critical part” of the risk management framework for cleared swap market participants.
  • SOFR Futures Open Interest has reached 497,724 contracts as of 10/29, up 19% in just 2 weeks since the October 16th Discounting Transition.

When the Secured Overnight Financing Rate (SOFR) was selected as the new overnight repo rate in 2017, the market’s focus immediately turned to one thing: transition. How would participants in a market that averages around $1 trillion daily in transactions move to a new rate from the incumbent LIBOR?

In October, a big part of the answer came when the discounting and price alignment rate on more than $7.2 trillion notional in U.S. dollar Cleared Interest Rate Swap products at CME Group were transitioned successfully from Fed Funds to SOFR.

The event marked the completion of step four of the Alternative Reference Rate Committee’s (ARRC) SOFR transition, and has since led to increased trading in SOFR futures.

“The change of discounting curves from Fed Funds to SOFR was an important part of the ARRC’s Paced Transition Plan,” said Tom Wipf, chair of ARRC and vice chairman for institutional securities at Morgan Stanley.  “For those that clear derivatives at CME or LCH, SOFR is now a critical part of their valuation and risk management frameworks, which should further increase familiarity with SOFR as we proceed along the LIBOR transition.”

ARRC had previously identified SOFR as the benchmark, promoted liquidity growth of SOFR-based markets and encouraged standardizations of existing fallbacks for interest rate derivatives as part of its Paced Transition Plan.

Preserving Portfolios

For their part, CME Group and LCH had to ensure that valuation in client portfolios was preserved and value in trades and portfolios were moved to SOFR.

CME Group Global Head of Interest Rate Products Agha Mirza said CME also had to make sure clients’ market exposure was preserved. Therefore, SOFR-Fed Fund basis swaps were exchanged to ensure that each client's risk was maintained.

In addition, 200 market participants took part in a voluntary auction facility designed to flatten positions that certain clients did not want.

“All of that resulted in a smooth and successful discounting transition from Fed Funds to SOFR-based discounting and price alignment,” said Mirza. The transition took place at market close October 16.

The transition led to $84 billion in cleared swaps at CME, a 185% increase in volume over September. Open interest in in the second year 3-month SOFR futures strip, so called “reds” contracts have now increased five-fold since the beginning of 2020, and 320 market participants have cleared $309 billion in SOFR swaps to date.

Where Do We Go From Here?

With the completion of the discounting and price alignment rate transition, ARRC’s next steps move to cash markets. Wipf says this includes “continuing thought leadership on construction of new SOFR-based cash instruments as well as pursuing solutions for problems with ‘tough legacy’ instruments.”

Beyond that, SOFR-based reference rates will be created, which are intended to be calculated by interest rates from SOFR futures prices.

Fallbacks

The top priority for ARRC, however, is the improvement and strengthening of the fallbacks for derivatives. The International Swaps Derivatives Association (ISDA) announced they are launching a protocol that will install new SOFR-based fallbacks as of January 25, 2021.

“The next big milestone will be to gather broad market adherence to the ISDA protocol, which will secure legacy uncleared derivative transactions with fair and transparent fallback language,” said Wipf.

He added that the significance of the October transition is in where it leaves SOFR as a rate, and the ease participants should now have in fully converting to the new reference created just three years ago.

“It will introduce significant liquidity into the market for SOFR derivatives, prompting expanded use of SOFR products,” said Wipf.

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