The Libor transition – Let’s talk about SOFR

Time is ticking down to Libor’s planned decommission date of December 31, 2021. Firms need to move quickly to execute their transition strategies, and having unique insight into certain key issues can aid decision-making. Numerix’s Ping Sun discusses transition timelines, secured overnight financing rate (SOFR) volatility, curve construction and the market implications for SOFR-based futures and swaps

The UK Financial Conduct Authority and the Bank of England, among other groups, have stressed the importance of holding firm to original transition timelines, but have also suggested interim milestones may be affected, meaning they could be postponed. What do you think of that statement?

Ping Sun: From the perspectives of regulators, central banks and clearing houses, the main concern is that any change to interim milestones could cause a chain reaction that might ultimately delay the final Libor transition. As such, the authorities are very cautious regarding any proposals to postpone interim milestones. Nonetheless, under the current market circumstances, there may still be a chance that some of the most immediate milestones could be pushed further. 

More broadly, the state of financial institutions’ transition readiness is very important. To this end, the market turmoil we are experiencing doesn’t help. In Covid‑19, we are certainly in an extremely strenuous situation. It is difficult to manage resources during the pandemic and a period of high volatility in the markets, whereby most working conditions may lead to less focus on preparations for the Libor transition. However, from what I see right now, many Numerix clients are preparing intensively for this transition and, hopefully, will continue to do so. 

 

Market participants have a lot of concerns. What is the top priority for Numerix’s clients?

Ping Sun: We find there is a huge demand for information covering a variety of issues. For instance, there are questions on where to obtain high-quality risk-free rate (RFR) derivatives market data while market liquidity is still developing. It is worth noting that in a recent global market survey Numerix conducted on the Libor transition, 29% of survey participants selected the lack of alternative reference rate liquidity as the primary challenge to transition efforts. 

Concerns around how to strip the RFR curves is also among the most frequently raised topics. Market practitioners want to make sure they have the right curve analytics needed to strip the RFR curves to price and trade the newly introduced RFR derivatives, as well as to manage the associated risks. Further down the road, the impact analysis of the discounting switch and, ultimately, the Libor fallback is of great interest. For both pricing and risk management purposes, RFR volatility is an important starting point. To this end, time series data of RFRs are the only available sources of information, given that the RFR option market has yet to grow.

Many of Numerix’s clients are asking for help in developing and executing their road maps, planning their next steps for the issues they want to handle, and working with Numerix to determine the solutions to the challenges they face. 

 

One example of SOFR volatility, on March 19, saw a big move in the spread between three-month USD Libor and SOFR. It reached 113.5 basis points, but was at 13bp only a month earlier. If Libor had ceased to exist on March 20, contracts that had been referencing a 13bp spread would suddenly have started referencing a rate 100bp higher. What are your thoughts on this spike in volatility? 

Ping Sun: Volatility of the SOFR versus Libor spread is expected because Libor contains the credit component and the liquidity component. Additionally, during the global financial crisis that began in 2007–08, the spread between Libor and the effective Federal funds rate (EFFR) was close to 350bp. Therefore, the number being above 100bp of difference doesn’t seem too wide, even when compared with when SOFR was first published in 2018 with a spread of around 60bp. 

People have good reason to be concerned about the fallback methodology. The International Swaps and Derivatives Association fallback protocol is to use the median over a five-year lookback period to define the Libor-SOFR spread. This certainly doesn’t reflect the current market spread between SOFR and USD Libor. There would be quite a significant amount of value transfer if the cessation of Libor were to happen right now.

In addition, market participants need to understand how rate behaviour impacts their trades and their positions in various products. SOFR has so far proved to be extremely sensitive to the liquidity in the repo market, although in a different form from that of Libor. In the past, we saw many regular spikes in the SOFR fixing, around and above the magnitude of 10bp, as a result of the month-end, quarter-end and year-end liquidity issues. This kind of volatile behaviour means that when people try to model the SOFR rates, they must keep in mind it might be something quite different from what they’ve seen in the past in EFFR and Libor, where the magnitudes of spikes and dips were at most several basis points. 

Furthermore, it should be considered that RFRs are not directly utilised in financial products. Instead, they are used in terms of the so-called backward-looking, compounded-in-arrears term rate, at least in the derivatives market. This means you need to compound the RFR over a certain period of time – in many cases three or six months – and those geometrically averaged rates are actually your underlying. To this perspective, when you look at the historical fixing of the compounded rates, the volatility of those SOFR term rates are much lower than that of Libor or SOFR itself. The New York Federal Reserve started to publish the backward-looking SOFR term rates in March of this year.

Market participants also need to look into the possibility that the volatility of the rates could drive SOFR or Fed funds rates to go to negative, which are in the range of only several basis points above the zero interest rate.

 

Has the market chosen the right replacement rate for USD Libor? What gives you comfort that SOFR will be a stable enough rate?

Ping Sun: The question of whether SOFR is the right choice has been raised since it was first designated as the replacement rate for USD Libor. The SOFR underlying market is very solid and is being actively traded, which is a positive sign. Even in March, the daily transaction volume in dollar amounts was more than $1 trillion. Market participants – rather than worrying about the underlying market – may instead closely track the liquidity of the derivatives market on top of SOFR. From what we see in the swaps and futures markets, the trading volume has so far been gathering strength. Hopefully, the trend won’t be interrupted by Covid‑19. Since the transition period will take place until the end of 2021, there is very likely still time to develop a more liquid derivatives market, so people can define their SOFR curve and forward-looking term rates based on the actively traded vanilla derivatives. Meanwhile, there is no good alternative that I believe can attract enough market consensus or receive blessing from the US Federal Reserve.

Meanwhile, for SOFR to be applied in all market sectors – especially where market stress needs to be reflected in the reference rate, such as loans – the lack of risk sensitivity in an RFR such as SOFR is a concern. Possible approaches are being explored to add on top of SOFR certain risk-bearing spreads to address this issue. Alternatively, the possibility of using unsecured reference rates in the cash market, such as Ameribor, is being discussed as well.

 

SOFR offers a choice of different instruments that can be used to construct a curve. How can the behaviour of these different instruments affect the kind of SOFR curves you can derive?

Ping Sun: In the SOFR market, the available derivatives that may currently be used to construct a SOFR curve are the SOFR one- and three-month futures in the front, and, at longer tenors, the SOFR overnight index swap (OIS) and the basis swaps of SOFR versus Fed funds, and SOFR versus the three-month Libor. With market liquidity still developing, different instrument choices can very likely result in very different curves.  

As of today, the liquidity of SOFR swaps is still a concern, especially when it comes to curve stripping. The overall SOFR swap trading volume is less than 1% of that of the USD Libor swaps. Among the SOFR swaps, the liquidity of the SOFR OIS is slightly better than that of the SOFR basis swaps. However, when the discounting switch happens this October, it is expected the demand in the SOFR versus Fed funds basis swaps would get boosted to hedge the SOFR discounting risk.

The response of SOFR derivatives to the market stress is also an important subject. For example, during the spring the SOFR versus Libor basis spread increased significantly to more than 100bp in the front tenor of three months, as has the SOFR versus Fed fund basis, though not to that magnitude. For the latter, the level of increment in the front is about 10–15bp. On the other hand, for the longer tenors you don’t see much change in the basis spread, likely due to the market’s view on the upcoming fallback being hinged on the five-year historical median. Of course, due to much less trading activity at longer tenors, liquidity is also of concern.

As a result, when you try to build the SOFR curve, you may still use the SOFR futures in the front, which are currently the most liquid SOFR derivatives. In the range from two to three years and onward, you may need to look into the SOFR OIS or the SOFR basis swaps with the Fed funds or Libor. The particular choice of the instruments is dependent on the usage of the SOFR curve. The SOFR versus Fed funds basis swap is more relevant to the discounting switch, while the SOFR versus Libor basis swap concerns the Libor fallback. 

 

Libor Risk – Quarterly report Q3 2020
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