At a high level, CME plans to copy the ISDA fallback methodology, replacing the forward looking LIBOR by a backward looking SOFR composition and a fixed spread. The spread will be the same as the one computed according to ISDA planned new definitions. If the goal is to mimic the ISDA new definitions, it appears to us that the CME proposal is a good methodology ... in theory.
As always, the devil is in the details. Among those details are the convexity adjustment (already described in the working paper Overnight Futures: Convexity Adjustment, February 2018. Available at SSRN: https://ssrn.com/abstract=3134346) and the difference in volatility between LIBOR and OIS (Hybrid Model: A Dynamic Multi-Curve Framework, August 2018. Available at SSRN: https://ssrn.com/abstract=3237403).
Another detail that was briefly touched on in the CME webinar is the difference in period on which the rates are computed for LIBOR futures and SOFR futures. To which we have to now add the 2 business day shift in ISDA OTC LIBOR fallback.
In practice what is the magnitude of those "period adjustments"? This is one of the elements we have looked at in our analysis of the transition. The table below reproduces the disparities in days using the SOFR futures as base and the ED futures and OTC theoretical compounded in-arrears (under the hypothesis that the LIBOR period is used as reference for the in-arrears computation). We have simply displayed the figures for 2022.
| Futures month | OTC start | ED end | OTC end | ED length | SOFR length | OTC length |
|---|---|---|---|---|---|---|
| Jan-22 | -5 | -1 | -6 | 90 | 91 | 90 |
| Feb-22 | -2 | -2 | -6 | 89 | 91 | 87 |
| Mar-22 | -2 | 1 | -1 | 92 | 91 | 92 |
| Apr-22 | -2 | 0 | -2 | 91 | 91 | 91 |
| May-22 | -2 | 1 | -1 | 92 | 91 | 92 |
| Jun-22 | -2 | -6 | -8 | 92 | 98 | 92 |
| Jul-22 | -2 | 1 | -1 | 92 | 91 | 92 |
| Aug-22 | -2 | 1 | -1 | 92 | 91 | 92 |
| Sep-22 | -2 | 0 | -2 | 91 | 91 | 91 |
| Oct-22 | -2 | 1 | -1 | 92 | 91 | 92 |
| Nov-22 | -2 | 1 | -1 | 92 | 91 | 92 |
| Dec-22 | -2 | 6 | 2 | 90 | 84 | 88 |
| Min (2020-2031) | -5 | -6 | -8 | 89 | 84 | 87 |
| Max (2020-2031) | -2 | 6 | 2 | 92 | 98 | 95 |
As can be seen, the OTC start date can be between 2 and 5 days before the SOFR futures start date. The end between SOFR and ED futures is anything between -6 and 6 days. The end between SOFR futures and fallback OTC is anything between -8 and 2 days. You can also see the differences in term of accrual period length.
Obviously those difference in length means a different hedging efficiency between the current LIBOR framework and the after fallback SOFR framework.
The code used to produce the table above can be found (open source) on the GitHub marc-henrard/analysis repository at https://github.com/marc-henrard/analysis/blob/master/src/analysis/java/marc/henrard/analysis/fallback/FallbackEurodollarFuturesDatesAnalysis.java
Don't hesitate to contact us for more details on our research and tools related to the LIBOR fallback for OTC and ETD derivatives.