Sunday, 26 June 2022

USD STIR Futures: SOFR progress ... but still too much LIBOR

We are six months into the "now new USD-LIBOR risk traded" period as announced by regulators. We had a look at the situation through the eyes of the STIR futures market at CME.

USD-LIBOR futures have been the most liquid STIR futures for many years. The new SOFR futures and the "SOFR First" initiatives should have shifted the volume.

In Figure 1, the daily volume at CME is displayed. One can see that SOFR-3M futures have now a higher volume than LIBOR-3M futures. But this is a recent phenomenon that appeared only in May and the advantage of SOFR is small. Over last (short) week, the SOFR volume as only 20% higher than the LIBOR volume.

Figure 1: Daily STIR Futures volume at CME.

On the open interest side, LIBOR is still largely above SOFR with an excess OI of 75%. More details are displayed in Figure 2. Moreover LIBOR OI as only decreased slightly since the start of the year, from 11.2 m contracts to 9.6 m (-16%). A large part of the decreased came when existing contracts came to expiry. Since the beginning of the year, the total LIBOR futures volume has been 265.8 m contracts. The decrease in OI correspond to 0.7% of the traded volume. We are extremely far away from a situation were the new LIBOR trades are risk reducing!

Figure 2: Open Interest in STIR Futures.

Another feature of the futures market is the expiry date of the contracts traded. LIBOR with cease in June 2023. One could claim that trading LIBOR contracts with expiry before that date make sense from a risk management perspective and is in line with the spirit of the SOFR first requirement in the sense that those trade do not add to the transition effort which is not needed before June 2023. But the expiry profile of the futures traded does not look like that at all. If we take the traded volume for quarterly contracts on Friday 24 June, we get a expiry profile displayed in Figure 3.

Figure 3: Daily volume on 24 June 2022 for the different quarterly expiries.

The SOFR-3M futures are dominating overall, but for the maturities beyond June 2023, LIBOR is dominating. The higher LIBOR volume is even more important on a relative basis for longer expiries. If we take contracts with maturity beyond 5 years (June 2027 and beyond), the LIBOR volume is 27 times higher than the SOFR volume. Is there some market participants betting on the transition not taking place in the next 5 years?

This leads to a question we have asked for some time, without finding an answer. Or more exactly finding plenty of answers, but all bad (and scary) answers. The question is

Why do financial institution still trade LIBOR futures/swaps?

In the different seminars on SOFR that we are presenting, we use the following slide to put the question in perspective.

Figure 4: Why do financial institution still trade LIBOR futures/swaps?

  • Investment universe. SOFR products not approved by the investment committee.
  • Validation Model. validation had no time to do a full validation of the new products.
  • Systems. The system (risk/accounting) cannot cope with the SOFR products / the composition in-arrears.

Those reasons are valid reason from a very short term practical perspective, but certainly not valid 5 years after the "Future of LIBOR" speech by FCA, 4 years after the creation of SOFR and 1 year after one knows about the actual cessation date. It can take time to change systems, guidelines and validate changes. But by trading LIBOR products, you are only lying to yourself and hiding your weakness to yourself, not solving any of them. At the very least I would expect participants to trade the real think (SOFR swaps and futures), without frankensteins-like fallback, and book/report them in the best way they can. That could simply be to create swaps/futures linked to SOFR term rate (same system complexity as LIBOR) and adjust the booking as soon as possible. At least you will represent the bulk of your risk correctly and link it to SOFR!


Don't hesitate to contact us for advisory work related to the transition, the associated model developments, validation, or implementation.

Wednesday, 15 June 2022

ESTR: Volume and term rate

This week, SOFR as usual (small progress) but important news on the ESTR side. EMMI (the administrator of EURIBOR and the disappeared EONIA) has started to publish a ESTR Term rate (in beta version).

The Term rates are unfortunately not part of the fallback in the derivative ISDA definition but the Euro Risk Free Rates Working Group has recommended a forward-looking term rate as a fallback for EURIBOR for certain asset classes.

This new step in the direction of a term rate is accompanied by an important surge in the ESTR-OIS volume as can be seen in Figure 1. The weekly volume was around USD 6.8 trillions. By comparison SOFR volume was around USD 3.2 trillions, less than 50%.

Figure 1: Weekly ESTR volume at LCH.

As described in several SOFR related blogs and seminars (e.g. here), the share of the ESTR short term trades (in gray in Figure 1) is quite high. The ESTR liquidity is concentrated where it is important to have a robust ESTR Term rate. This is by opposition to USD-SOFR where only a small part of the volume is short term and the recommended SOFR Term rate is based on futures which require an arbitrary interpolation schemes and un-hedgeable time weights.

Also in relative terms, ESTR is taking more importance. As displayed in Figure 2, the ESTR share has reached 60% last week, to be compared with SOFR share at 37%.

Figure 2: Weekly share by product type at LCH.

Tuesday, 7 June 2022

LIBOR to SOFR transition: 3 June figures

The week before last saw a large increase in SOFR volumes at LCH. Last week, the SOFR share stayed high, at 38.4% but in a market with lower total volume (See Figure 1 and 2).

Figure 1: Weekly share by product types at LCH

x

Figure 2: Weekly SOFR volume at LCH and as reported by ISDA (US regulatory figures based).

The SOFR-OIS outstanding amount continues to increase steadily to reach close to USD 35 trn (see Figure 3); the amount is now largely above the EFFR amount. But the LIBOR-IRS outstanding amount is not really decreasing. At USD 82 trn, it is higher that January figures and more than twice the size of SOFR-OIS. Even if LIBOR weekly volume have decreased, the still large transacted amounts are certainly not all risk reducing. 

Figure 3: Outstanding amounts at LCH.

Tuesday, 31 May 2022

SOFR: significant increase in OTC volume

Last week has seen a significant increase in SOFR OTC volume. At LCH, the volume has been close to 3.7 trn, well above the 3.2 trn from beginning of March. The LIBOR volume has been only slightly below the year average, at 2.7 trn. The EFFR share continues to decline also. The weekly shares are displayed in Figure 1.

Figure 1: Weekly share by product types at LCH

The absolute numbers for the volume at LCH and as reported by ISDA are in Figure 2. The ISDA figures do not show such a large increase. [Note that at the time this post was first published, the ISDA figures for the week ending 27 May were not yet available; comment and graph updated accordingly].

Figure 2: Weekly SOFR volume at LCH and as reported by ISDA (US regulatory figures based).

Monday, 23 May 2022

LIBOR: Large OTC volume! SOFR: Large ETD volume!

Big increase in LIBOR OTC swaps volume this week!

Figure 1: Weekly share by product types at LCH


But on the futures side, we had, for the first time, a couple of "SOFR First" days last week from a volume perspective. The volume of SOFR-3M futures has been above the volume of LIBOR-3M futures from Wednesday to Friday (see Figure 2). The SOFR First is only in terms of volume, not in terms of open interest. In OI terms, SOFR-3M futures represent 50% of LIBOR-3M. Actually the 50% treshold was reached on Tuesday 24 May and now stands at 50.02%!

Figure 2: Daily STIR futures volume at CME.

The open interest for LIBOR-3M futures is decreasing very slowly. Since 31 December, the OI has decrease only by 7.2%. Note also that the total volume (SOFR+LIBOR) is significantly lower than previous peaks. It is not clear if this is structural or conjectural. But with uncertainty about monetary policy path, one could have expected a larger volume.

New published paper: Swap Rate fallback: unreasonable effectiveness of approximations and alternatives

A couple of months ago, we announced that the research paper written by Marc and titled

Swap Rate: cash settled swaptions in the fallback

had been accepted for publication in Risk. The article will appear in the June edition.

Since, that research has been deepened and we are pleased to announce that the follow-up article has been already accepted for publication in Wilmott Magazine. The article is titled

Swap Rate fallback: unreasonable effectiveness of approximations and alternatives.

Abstract

Cash-settled swaptions with collateral discounting are impacted by the Swap Rate fallback mechanisms decided by working groups/ISDA. The legacy vanilla swaptions are becoming exotic products, as the mechanism is based on a non-linear transformation of the OIS swap rate, and generate convexity adjustments. It turns out that those two effects almost cancel each other and lead to almost vanilla products. We analyse those cancelling effects and the risk management impacts. Based on those insights, we propose an adjusted fallback mechanism that reduces further the exotic features and simplify further the risk management of the legacy book.

The article should be published in the September issue. 

As a teaser, the graph below describes by which factor the "exoticness" of the fallback is reduced by our proposed alternative mechanism for different market movements. All the technical details are available in the paper.

Figure 1: Reduction in "exoticness" achieved by the alternative fallback proposal.


The summary of the results related to the alternative fallback method and the research paper have been communicated to the ARRC.

Added 7 June 2022: A preprint version is available on SRRN at: https://ssrn.com/abstract=4130090.


Don't hesitate to contact us if you are interested by the alternative to the ISDA fallback for swap rates. Cash settled swaption fallback can be a lot simpler than the current approach. Why not simplify your transition risk at no cost?

Tuesday, 17 May 2022

LIBOR-SOFR transition - still many unknowns

We start this week with a LCH consultation regarding the Conversion of Outstanding Cleared USD LIBOR Contracts. No big surprise in the content of the consultation itself. It is roughly the same a proposal for USD in June 2023 than the one for GBP in December 2021.

But this consultation is also the occasion to remember the uncertainty surrounding cleared LIBOR trades, the OTC versions at LCH and CME but also the ETD futures versions at CME. Each trade involving a LIBOR fixing beyond June 2023 need a precise fallback. The cleared trades don't have a precise fallback yet. The existence of the consultation, almost 5 years after the "Future of LIBOR" speech, is a reminder that the transition is still unplanned. The figures below illustrate that LIBOR still attracts more volume than SOFR. But a lot of those LIBOR-linked trade are for an unknown term sheet. 

The cleared swaps term sheet can be modified unilaterally by the CCPs using unknown mechanisms. The LIBOR futures will be transformed into SOFR futures at an unknown date and with unknown mechanisms. Yes, those mechanisms have been roughly described and there is an expectation that there will be little modification of them. But remember, for the ISDA definition, there was a consultation and then after the results were announced, the actual meaning of the different fallback mechanism was decided by Bloomberg! For cleared GBP swap at LCH, it was announced that the ISDA mechanism would be copied, only to decide later that a different mechanism would be used.

As model validators, we don't understand how the trading of Eurodollar futures or cleared LIBOR swaps can be validated from a quant perspective when the exact term sheet is still unknown.

Coming back to our weekly statistics, we see that at LCH, from a volume perspective, SOFR is still third. Five months into 2022, we certainly have not achieved "SOFR First" in a stable way.

Figure 1: Weekly share by product types at LCH

Last week, the SOFR relative volume was around 29.0%. It has been lower than both the LIBOR and the EFFR volumes for several weeks now. On an absolute basis, the volume has not been increasing either. Last week volumes at LCH and as reported by ISDA are lower than the one reported in February as displayed in Figure 2.

Figure 2: Weekly SOFR volume at LCH and as reported by ISDA (US regulatory figures based).

The futures do not paint a very different picture. The volume of LIBOR-3M futures is still above the volume of SOFR-3M futures each and every day, as displayed in Figure 3.

Figure 3: Daily futures volume at CME.

The activity in LIBOR futures is certainly not all risk reducing as regulators would like. Since the beginning of the year almost 222 million LIBOR futures contract have been traded. Over the same period, the open interest in the same futures has decreased by a pale 660,000 contracts. A maximum of 0.3% of the trades are risk reducing. We say "maximum" as a certain amount of trades expired on a monthly basis — we don't have the expiry figures so cannot adjust the above figure.

Tuesday, 10 May 2022

SOFR still third and other RFR's volume decreasing

For the second week in a row, SOFR is coming third in the benchmark race at LCH. Its share is down to 27.4%.

Figure 1: Weekly share by product types at LCH

On an absolute basis, the SOFR figures are not great either. The weekly traded notional was around 2.3 trn, which is a level similar to January. The volume has peaked at 3.2 trn at the beginning of April. The SOFR volume decrease is also visible in the ISDA/US regulatory figures.

Figure 2: Weekly SOFR volume at LCH and as reported by ISDA (US regulatory figures based).

If we look at the currencies for which LIBOR has been discontinued (GBP, JPY and CHF), we see a common behavior for the outstanding amounts at LCH: they are all decreasing since the start of the year (hyphened lines). We don't have a direct explanation. It can be a combination of: better use of compression for overnight, market participants less comfortable with OIS than with IRS, transfer to other CCPs (JSCC for JPY, EUREX for CHF), or something else. But certainly it is worth keeping an eye on it as it seems common to the three currencies.

Figure 3: End of week outstanding notionals at LCH for GBP (SONIA), JPY (TONA) and CHF (SARON).

Wednesday, 4 May 2022

SOFR: one step forward, one step backward.

Just one graph this week.

We are back to "SOFR Third" at LCH!

Figure 1: Weekly share by product types at LCH

Thursday, 28 April 2022

SOFR First - Step 1.5!

One month ago we published a blog titled "SOFR First - Step 1!". This was the fist week where at LCH there was more SOFR swaps traded than LIBOR swaps. We also indicated that for STIR futures at CME, LIBOR was still well above SOFR in volume terms.

This week we can indicate that "Step 1.5" in SOFR first has been reached. The daily volume of SOFR-3M futures is still less than the LIBOR-3M one, but for the first time, there was one day (Tuesday 19 April) where the combined volume of SOFR-3M and SOFR-1M surpassed on the LIBOR-3M one. You may have received some marketing email from CME indicated this milestone — even if the mail was not clear on the fact that this was achieved only by combining SOFR-3M and SOFR-1M. If you take the contract individually, LIBOR-3M has still more volume than SOFR-3M every single day. On the 1M side, EFFR-1M has still more volume than SOFR-1M every single day. This is why we call this step by the name of "1.5". The true "Step 2" will be when SOFR-3M volume is above LIBOR-3M volume and maybe "Step 3" when SOFR-1M volume is above EFFR-1M volume.

Returning to the LCH OTC cleared side, since that first "SOFR First - step 1" week, the SOFR, EFFR and LIBOR shares have battled for the leadership. The weekly shares are provided in Figure 1. SOFR hase been the main benchmark for a couple of weeks, but still far away from registering 50% of the OTC swap volume.

Figure 1: Weekly share of product types at LCH

The volume has been flat on an absolute basis over the last 8 weeks. The increase in market share is more due to the decrease in LIBOR and EFFR than the increase in SOFR.

Figure 2: SOFR volume evolution and share among tenors.

The oustanding amount has been steadly increasing for SOFR and has now reached the EFFR level. The LIBOR outstanding amount is almost unchanged since the beginning of the year, confirming that the activity on LIBOR is not all risk reducing.

Outstanding volume

Figure 3: LIBOR, EFFR and SOFR outstanding volumes at LCH.

The daily volume in STIR futures at CME is displayed in Figure 4. The "Step 1.5" is not directly visible on the graph, but by adding the SOFR-1M to the SOFR-3M volume on 19 April, the totla is larger than the LIBOR-3M volume. Up to know, this was a one-off. We will indicate the real "Step 2" in our blogs as soon as we see it hapenning.

Futures daily volume

Figure 4: Daily futures volume at CME.

On the open interest side, the situation is a continuation of the developments since the begining of the year. An very small decrease in LIBOR open interest — indicating once more if needed that the vast majority of the LIBOR trades are not risk reducing — and a significant increase in the SOFR open interest and a smalller one in EFFR open interest. The OI in SOFR-3M futures has not reach 50% of the LIBOR-3M futures yet. The increase in SOFR and EFFR is probably linked in part to the change in monetary policy and not only to the benchmark transition. The total STIR futures OI has significantly increased since the start of the year.

Figure 5: Futures Open Interest at CME