SOFR and ESTR: a real boom?

Over the last months, our analysis in relation to ESTR and SOFR has been something like "small improvements".

This week the summary could be: a real boom!

The situation is very different in USD-SOFR and in EUR-ESTR, even if the result are similar.

ESTR

Let's start with the EUR-ESTR. EONIA has been the main overnight benchmark up to recently even if EONIA is derived from ESTR as ESTR+8.5 bps since October 2019. In two years, the real underlying had not been able to overtake the old and broken incumbent. EONIA will stopped to be published as of 1 January 2022.

On 15 October, the CCPs have cancelled the existing EONIA swaps and replaced them by ESTR swaps. No more EONIA swaps at CCPs but many ESTR swaps. This is clearly visible in the graph below (LCH volumes).

Note that at almost the same time (on 21 October), the EU published a text of law mandating the replacement of EONIA by ESTR + 8.5 bps. When it was announced that EONIA data collection would be stopped (somewhere in 2018) and replaced by ESTR + spread, Marc said that he believed that the synthetic EONIA would last for very long. He was quickly proven wrong with the announcement that EONIA publication would be stopped on 1 January 2022.

Now he is proven right again by the law! Three years were no enough to deal with this transition. This is in line with another (even older) prediction: Change of benchmark overnight index is a difficult task. Another prediction was that EONIA would stay for a very long time in bank systems as a fixing and as a curve. Note that the EONIA replacement by ESTR+8.5bps is only for contracts for which the EU law applies.

SOFR

For SOFR, there was no specific news, but a real progress in term of volume nevertheless.

A significant increase in absolute volume both at LCH and in the ISDA figures (US regulatory figures). The relative volume is still below the 15% of the total LIBOR + SOFR. The USD market is still far away from SOFR first!

ICE Swap Rate fallback: impact on swaption pricing

Sterling and dollar working groups have proposed fallback for ICE Swap Rates (ISR) based on the mechanism used for LIBOR itself. It is not possible to create a ISR's fallback coherent with the LIBOR's fallback. Or more precisely it is possible (and easy) for a quant to do so, based on the swap market globally, but it is impossible for a lawyer in a definition involving only one number published on a single screen.

The self-imposed restriction on the type of fallback available make the existence of a coherent fallback impossible. In the absence of an exactly coherent fallback, the working groups tried to provide an approximately coherent one.

The impacts of those fallback go beyond simply printing a formula on a piece of paper and have profound impacts on the valuation and risk management of existing instruments like swaptions.

In particular cash settled swaptions with collateral discounting have a triple problem:

• Incoherent spread (delta hedge with swaps)
• Non linear pay-off
• ``Non-natural'' annuity, i.e. convexity adjustment

The incoherent spread was discussed by Marc in a previous blog: LIBOR transition: How to lose money, automatically!

In a forthcoming paper, we will show how those swaptions can be priced.

The one line summary of the pricing method is a change of strike in line with the non-linear rate transformation and a replication similar to the one used in CMS pricing.

Some early results have been presented in LIBOR transition workshops. A more detailed seminar related to the swaption pricing will be presented at The WBS 17th Quantitative Finance Conference.

Below we already proposed a graph that displays the non-linearity impact, the exact meaning of which will be discussed in the seminar. We will post a link to the full paper once published.

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Note added 20 October 2021: A preliminary version of the results were presented at The 4th Interest Rate Reform Conference today.

Note added 20 October 2021: I have added the ICE Swap Rate fallback formulas to my open source library muRisQ-ir-models at https://github.com/marc-henrard/muRisQ-ir-models/blob/master/src/main/java/marc/henrard/murisq/pricer/generic/FallbackIsrUtils.java.

SOFR volume to 8 October 2021

Usual review of SOFR volumes. After a small increase a couple of weeks ago that lead us to ask "Is something happening?", we are back to levels below mid-July level at LCH. ISDA figures indicate that SOFR is back to less than 10% of interest rate derivatives volume.

No real progress a little bit more than two months before the expected deadline for "no more LIBOR".

Short term swaps (less than 2Y) volume is not increasing either, which is not a good indication for the development of Term SOFR rates.