Tuesday 23 May 2023

US - Eurodollar futures a USD 8 million rounding error

Last week, Marc presented a workshop on the ”LIBOR transition: What could we have done better from a quantitative perspective?” at the CEETA Benchmark Congress in Warsaw.

Among the elements presented were the results of the fallback on euro-dollar futures at CME that were converted to SOFR futures. An interesting issue with the conversion is the number of decimals. The conversion was done using the ISDA/Bloomberg designed spread between USD-LIBOR-3M and the replacement SOFR of 26.161 bps. This is a number in basis points with three decimals. But the futures are quoted with only 0.5 basis point precision. A natural question is what happen to the extrta decimals? Simply it created a profit for those who understood it.

In the conversion, roughly 4 millions LIBOR futures were converted to SOFR futures, but the open interests in SOFR futures were almost unchanged. The 4 millions futures did not simply disappear, there were offsetting positions between the LIBOR and SOFR futures that had cancelling effects on the next day. The offsets were not between different market participants, but for the same participant having offsetting positions between LIBOR and SOFR futures. The spread between the two was known since 5 March 2021. The amount involved is 4,000,000 contracts with USD 1,000,000 notional each, this means USD 4,000,000,000,000 (4 trillions), not a notional resulting from an ignorant retail trader!

The closing price for the different futures on 14 April 2023 (the conversion date) were:

Closing prices Sep 23 Dec 23 Mar 24
ED 94.965 95.33 95.785
SR3 95.225 95.59 96.045
Spread (bps) 26 26 26

Take the strategy to buy SR3 at 95.225 and Sell ED at 94.965. The next day, the position is Long SR3 at 95.225 and Short SR3 at 95.22626. The total P/L is, irrespective of the price the next day: (P - 95.225) - (P - 95.22661) = 0.00161%.

The impact of rounding is (number of contracts x notional / basis points / quarterly / offsets * spread)

4,000,000 x 1,000,000 / 10,000 / 4 / 2 * 0.161 ~ 8,000,000

The rounding had an impact of USD 8,000,000.

Given that the spread is known since March 2021, one can guess that market makers have used any opportunity in the last 2 years to add ofsseting positions each time the tradable spread moved away from the 26.161 basis point. The actual arbitrage from the conversion is probbaly well above the figure indicated above.

Hopefully our readers were on the profitable side of the arbitrage.

Don't hesitate to contact us if you require advisory services related to the benchmark transitions.