LIBOR transition: approaching year end

We are approaching year end. One last "weekly" review before the yearly review next week. We have not been fully consistent with our weekly updates recently, but to our defense, there have not been huge changes in the weekly patterns.

The share between LIBOR, EFFR and SOFR are changing every week, but none of them is reaching 50%. So no real LIBOR, EFFR or SOFR first. The LIBOR share is decreasing but still significant.

Figure 1: Weekly share by product types at LCH

The LCH figures and ISDA figures (based on US regulatory filling) are saying basically the same thing. The trend is in the increase of SOFR and decrease of LIBOR, but it is not a smooth trend. No major change in the last 9 months.

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

From an outstanding notional point of view, LIBOR is decreasing, SOFR is strongly increasing and EFFR is slightly increasing. We are still more than 10 trillions away from SOFR First.

Figure 3: Outstanding amounts by benchmarks at LCH

LIBOR First (where have we seen that before?)

We have not posted on LIBOR transition/SOFR progress for a month, expecting the subject to slowly disappear with the final LIBOR date approaching. But looking at last week data, we have to conclude, once more that we are back to

LIBOR First!

Both in relative terms and in absolute terms, SOFR has not really progressed in the last month. There is more LIBOR volume than SOFR volume. At LCH the LIBOR/SOFR split is 33.9%/30.9% and for ISDA figures (no EFFR figures provided, only outright swaps) it is 53.7%/46.3%. The absolute weekly volume for SOFR is similar to the one of February. The outstanding amounts are stable both for LIBOR and SOFR, SOFR is not catching-up anymore. The LIBOR volume is not risk decreasing. Note that a decent amount of LIBOR activity is probably in single period swaps (SPS, replacing the FRAs due to incoherent LIBOR fallback rules). The data available does not distinguish between the SPS and tenor swaps.

Figure 1: Weekly share by product types at LCH

Figure 2: Outstanding amounts by benchmarks at LCH

Figure 3: Weekly SOFR volume at LCH and as reported by ISDA (US regulatory figures based).

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A different perspective on the LIBOR/SOFR data from Clarus: What’s New in Term SOFR?

LIBOR fighting back!

A couple of graphs from last week. It appears that LIBOR is fighting back against SOFR!

From the ISDA figures, SOFR outright is well below LIBOR outright (SOFR around 40% of the market).

Figure 1: Weekly volume for SOFR at LCH and as reported by ISDA (US regulatory figures).

At LCH, the SOFR swaps represented around 36%. Remember ISDA does not report EFFR data and it is based on regulatory figures (notional well below the notional traded at LCH).

Figure 2: Weekly share by product types at LCH

The larger than in the previous weeks LIBOR notional is not linked to cancellations or risk reduction. If anything, the LIBOR outstanding notional has increased over the last weeks.

Figure 3: Outstanding USD derivatives volumes at LCH.

Bond futures delivery option - back to ATM

For a very long times rates on government bonds have been low. In particular they have been low with respect to the “notional rates” used in computing the conversion factors in bond futures.

Those rates were traditionally at 6.00% and are still at that level for US Treasury futures and most of German bonds futures. For the German bonds, the exception is the ultra long bond futures which are based on a 4.00% notional coupon. On the UK Gilt side, most of the notional rates are at 4.00% with the exception of the Short Gilt Futures based on a 3.00% notional coupon.

The recent market movements have brought the UK Gilt rates around 4.00%. Does this matter? What is the impact of the “notional rates” on the behaviour of bond futures?

Bond futures are settled by the physical delivery of a bond. The deliverable bonds are government bonds with a specific maturity range (plus some other conditions on size). The amount paid at delivery for the bond is the futures price multiplied by a “conversion factor” (and the notional). This conversion factor is computed (as a clean price) from the actual bond and from the notional rate. The impact of all this is that the notional rate act as some kind of strike. If the yield is below the notional rate, the shorter maturity bond is usually the cheapest-to-deliver; if the yield is above that rate, the longer maturity bonds is usually cheapest-to-deliver.

They are subtilties around that long/short maturity, in particular dependent on the coupons, as the EUR market has reminded us recently (see  Bund volatility sparks uncertainty around futures delivery).

The delivery option that had been forgotten for a long time is now back in the discussion. A good opportunity to referenced to a more than 15 years old paper by Marc: Bond Futures and Their Options: More than the Cheapest-to-Deliver; Margining and Quality Option (2006).

Obviously, the techniques to analyze this issue have evolved over the last 15 years, and we have implemented several of them. Those proprietary developments are currently not available publicly, but are available to our advisory clients.

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Don't hesitate to contact us if you are interested by modelling embedded options in vanilla products.

Is SOFR first genuinely starting?

"SOFR first" has been mentioned for a long time and was suppose to start in July 2021. There have been many partial achievements along the way. To our opinion, last week was the first time we can mention SOFR First without adding inverted commas around it.

The LCH data indicates that more than 50% of the USD LCH-cleared interest rate derivatives was based on SOFR. Up to now, the achievements had been relative, like "more SOFR than LIBOR". This time, we can really say for the first time "SOFR dominates the USD rate benchmarks".

Figure 1: Weekly share by product types at LCH

Milestone 100 trillions

Last week the 100 trillions milestone has been reached. The YTD volume at LCH passed that milestone for both LIBOR and SOFR on the same week. Emphasizing if needed that if we are in a "SOFR First" period, it is only by a very small margin.

The YTD numbers were on 2022-09-16: LIBOR 100.29 trn, SOFR 101.85 trn and EFFR ... 130.32 trn. If SOFR beat LIBOR by the smallest of margin, it is still more than 25% below EFFR.

Figure 1: Weekly share by product types at LCH

The recent period has seen several monetary policy changes in EUR and USD. The activity around those policy changes is clearly seen in the EUR-ESTR volume data, a lot less in the USD-SOFR data. For USD, EFFR still take a large part of the short term activity.

The comparison between EUR-ESTR and USD-SOFR is provided in Figure 2. The usual clear difference in the short part of the curve is clearly visible.

Figure 2: USD-SOFR and EUR-ESTR weekly volume comparison.

Oops again - back to SOFR Second

Each week brings a new "MyBenchmark First" moment. This week, the winner is EFFR!

Figure 1: Weekly share by product types at LCH

Back to SOFR First - LIBOR Futures transition

A couple of weeks ago we were back to LIBOR First, this week we continue the back and forth and it is ... SOFR First.

Figure 1: Weekly share by product types at LCH

On the LIBOR futures side, CME has announced its proposed conversion date for the LIBOR futures to SOFR futures: 14 April 2023. It is a good news that we now have a date. But it also means that anybody who has traded a post June 2023 LIBOR futures in the last years did not know what he was trading! The cessation of LIBOR in June 2023 has been announced a couple of years ago (on 5 March 2021) but the LIBOR fallback for one of the most liquid LIBOR instrument is only announced now. Actually it is not even the definitive fallback that is announced now, but only a "proposal" that has still to go through regulatory approval and consultation. 

What is the impact of choosing the date 14 April 2023 on the pricing of the futures? If you cannot answer that question, maybe you need external help/advise on the transition. A detail answer is part of our "Benchmarks in transition" course.

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Don't hesitate to contact us if you are interested by benchmark transition advisory or training.

LIBOR transition: Back to LIBOR first - again and again!

Last week, we were saying "SOFR: slowly getting to SOFR First"; this week it seems we have to take that back. This week title is LIBOR transition:: Back to LIBOR first - again and again!, as reference to the "LIBOR Transition: Back to "LIBOR First" - again!" post from one month ago. The reason is the same, LIBOR appears very sticky. Each time the market seems to definitively move to SOFR first, LIBOR comes back with a vengeance and take over again. 

Figure 1: Weekly share by product types at LCH

The LIBOR return is visible both in LCH numbers displayed in Figure 1 and in ISDA-US regulatory numbers visible in Figure 2. In both cases, the weekly volume for LIBOR is above the weekly volume for SOFR.

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

At the outstanding amounts level, the picture is not very different. Over last week, outstanding LIBOR amounts have increased (slightly). The LIBOR volume is far from being "risk reducing". The outstanding SOFR volume is below its peak from 2 weeks ago as visible in Figure 3. 

Figure 3: Outstanding amounts by benchmarks at LCH

More than 5 years after the "Future of LIBOR" speech, almost 18 months after the announcement of the definitive LIBOR dismissal and more than one year after the SOFR First announcement; LIBOR is back to the forefront.

SOFR: slowly getting to SOFR First

More than 5 years after the "Future of LIBOR" speech, almost 18 months after the announcement of the definitive LIBOR dismissal and more than one year after the SOFR First announcement; LIBOR is still traded in huge amounts. Only for last week LCH cleared IRS, there was 1.3 trillions USD traded.

But we see a slow progress. LIBOR volumes and outstanding notionals are slowly trending downward with some ups and downs; SOFR volumes and outstanding notionals are slowly trending upward with some ups and downs.

Figure 1: Weekly share by product types at LCH

Speaking of outstanding amount, the SOFR outstanding amount at LCH has decrease last week by 895 billions, the highest decrease ever. Nothing to be afraid of as there is a lot of short term products and they come naturally to maturity. But it may mean that we are approaching the "SOFR" peak. Note also that in term of outstanding amounts, SOFR is still well behind LIBOR with a 40 v 74 (trillions) score.

Figure 2: Outstanding amounts by benchmarks at LCH

Note that the "CME Conversion for USD LIBOR Cleared Swaps" rules have just been published. It means that since 2017, the market has been trading instrument linked to LIBOR, knowing that LIBOR would disappear and is only learning now what it has been trading for the last 5 years! Not a big success in term of transparency.

SOFR: holiday and recession

It is difficult to get a clear message from a market which is half in holiday and half in recession. From the SOFR market, we could say, once more, nothing special to say.

The share of SOFR in the LCH cleared OTC IR market is playing ups and downs around one third of hte market. The changes are as much related to LIBOR and EFFR as to SOFR. The current SOFR share is not very different from the one mid-March.

Figure 1: Weekly share by product types at LCH

On the absolute volume, the holiday mood is clear, with the current weekly volume at merely 62% of the mid-June volume.

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

On the subject of LIBOR transition, we looked at the outstanding notionals at LCH in the different currencies. We noticed again a relation between the transition to overnight rates and the total outstanding notionals. Since the beginning of the year, all the currencies that have fully transitioned (GBP, CHF, JPY) have seen significant decreases (GBP -15%, JPY -42%, CHF -37%), the currency that has half transitioned (USD) is almost stable (+3%) and the currency that has not transitioned at all (EUR) has seen a significant increase (+19%). The origin of this relation is not clear. It can be completely random, or it can be that the end users have decrease their risk management program as the new overnight world does not fit their needs, or it can be something else. But certainly a trend to check in the future.

Swap Rates and Term Structure Modelling: Implementation

Swap rate dependent products, e.g. CMS, have a long history in interest rate modelling. They look simple as only one rate is involved, but when the rate is not paid in a natural way, i.e. not according to its own annuity, they involve some type of "convexity" or "timing" adjustment.

Those products are often priced using "replication", but to do so, some approximation of the annuity discounting, or absence thereof, is used. This type of single factor approximation is what we used in our recent paper on pricing cash settled swaption through the fallback published this month in Risk (Henrard (2022)).

A very recent paper Bang and Daboussi (2022) is proposing a new approach to price swap rate dependent products in a way that preserves the full marginal distribution of all the swaps and a user selected copula between those rates.

The implementation is not trivial from a quantitative finance perspective (two changes of measure) and implementation (Monte Carlo). But by the way the numerical approach is cleverly designed, the simulations are not too costly and converge quickly.

We have adapted the methodology proposed by the authors to take into account conventions (accrual factors not all the same and the T+2 payment/effective date) and implemented it in our library. This is the library we use for consulting and model validation purposes.

The results we have observed are very good. In their paper, the authors compare the (input) market smile to the (output) model generated smile for vanilla options and find a very small discrepancy, i.e. the numerical noise is small on the present value. We have obtained the same results. We have also done the comparison for the smile risk which was not presented in the paper. We computed the sensitivities to the alpha, beta, rho and nu parameters in a SABR model. In our implementation, the sensitivities are obtained by Algorithmic Differentiation (AD) as you would expect. For a 2Yx5Y swaption, here is the comparison between the analytic result (direct formula for the vanilla) and the Monte Carlo with AD version:

As you can see, the numerical noise is below 0.05% of the actual number on the alpha-vega (a little bit higher for nu and rho). This was obtained with a relatively low number of Monte Carlo paths (1,000).

Why we are interested by this approach, beyond its natural application to CMS, is for the above mentioned fallback of cash settled swaptions with the LIBOR-linked swap rate discontinuation.

With a precise view of the term structure smile risk in CMS-like products, we can now have a look at term structure smile risk for the fallback. That will be the subject of a forthcoming blog.

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Henrard, M. (2022). Swap rate: cash settled swaptions in the fallback. Risk, Cutting Edge. Published online 1 July 2022. https://www.risk.net/cutting-edge/banking/7951001/swap-rate-cash-settled-swaptions-in-the-fallback

Bang, D. and Daboussi, E. (2022). Modelling of CMS-linked products in an RFR framework, with extension to hybrids, forward starting and canary options. SSRN 4134438. https://ssrn.com/abstract=4134438

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Don't hesitate to contact us if you are interested by model developments or model validation related to swap rate linked products like CMS.

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Added 2023-05-07: The implementation notes for this model have now been published in the muRis_Q Advisory Implementation Notes series. See the new related post.

LIBOR Transition: Back to "LIBOR First" - again!

Same title as 3 weeks ago!

LIBOR is again the first benchmark in USD this week at LCH!

Figure 1: Weekly share by product types at LCH

LIBOR, EFFR and SOFR still playing yo-yo!

USD-LIBOR trading should have stopped more than 6 month ago, but in the market figures there is still large activity around it. From week to week, the dominant benchmark in the USD derivative market change from LIBOR to SOFR to EFFR. Last week the winner was EFFR, the week before it was SOFR and another week before is was LIBOR.

Figure 1: Weekly share by product types at LCH

We are still far away from a all-in in SOFR; maybe we will never go there!

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

Getting closer to SOFR First!

Getting closer to SOFR First! The SOFR share at LCH was last week at 43.7%, highest share and getting closer to 50%.

Figure 1: Weekly share by product types at LCH

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Note that there is no more LIBOR swaps outstanding at LCH in GBP and JPY. We had to wait July to make such an announcement as the last LIBOR-6M, fixed at the end of December, were paid at the end of June (GBP, T+0) and beginning of July (JPY, T+2). In CHF, there is still CHF 30 millions of LIBOR swaps outstanding; this is probably a LIBOR-12M swap with one coupon still to be paid.

LIBOR Transition: Back to "LIBOR First"

For the first time in a while, we are back to "LIBOR First" at LCH and for US regulatory figures.

Figure 1: Weekly share by product types at LCH

The story told by the ISDA published US regulatory figures is similar (see Figure 2). For those figures also, LIBOR is back to the fore. This can be seen with the ratio SOFR outright/(LIBOR+SOFR) which is back below 50%.

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

There are more and more discussion about allowing a wider use of the SOFR Term rate. This is based on its usage in cash products. Derivatives are (or at least should be) designed to help risk management. If derivatives cannot be based on the same underlying benchmark as the cash product, they become less useful. This is the case for Term Rate based swaps but also optional products like cap/floor. Some cash products have explicit or implicit cap or floor, but currently they cannot be hedged easily in the wholesale market.

Issues regarding the SOFR Term rate itself can also been seen in Figure 2. The short term part of the SOFR-OIS (less than 2 year) is not large. This means that it is difficult to established a term rate based on liquid regulated electronic trading venues (Level 1 waterfall). We have mentioned this issue in several blogs and presentation (see here for example). Currently, CME SOFR Term rate is based on level 3 of the waterfall (futures) and IBA SOFR Term rate is based on level 2 of the waterfall (dealer to client). Also when using futures, creating the term rate requires some arbitrary interpolation scheme choice and has some timing issue.

With only one year to go to the LIBOR end date, this is not very good for the transition!

Published paper: Swap Rate: cash settled swaptions in the fallback

The paper on the swap rate fallback and its impact on cash-settled swaptions announced in March has now been published in Risk.

Swap Rate: cash settled swaptions in the fallback

The paper is available on the Risk web site at

www.risk.net/7951001.

Abstract

With the planned cessation of LIBOR, the LIBOR-based Swap Rates will also cease. For legacy transactions linked to it, a fallback is required. Some approximated fallback mechanisms have been proposed by working groups. The approximations involve some non-linear function of overnight-based swap rates. Due to the non-linearity, cash settled vanilla swaptions are becoming exotic products. Moreover, keeping the annuity unchanged while changing the rate to overnight-based swap generates technical issues in the pricing leading to convexity adjustments. The article proposes different pricing methodologies for those now exotic swaptions, including several price approximation to reduce the implementation numerical complexity.

One graph from the paper: Error between replication with annuity ratio and order 2 approximation.

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!

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

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.

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.

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).

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

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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.

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

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

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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?

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.

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).