Banks mull structured notes as term SOFR basis hedge

Banks are exploring how structured notes could be used to offload a basis risk between interest rate swaps referencing the US secured overnight financing rate (SOFR) and a term version of the benchmark, which is piling up on dealers’ balance sheets, Risk.net can reveal.

The nascent plans could hit regulatory roadblocks, however, as a representative of the Federal Reserve-backed group overseeing the transition away from Libor indicates the activity may conflict with guidelines around the use of the forward-looking benchmark.

It is understood that discussions around using structured notes to offload term SOFR basis risk have taken place on the rates desks of at least three global banks.

“We’re trying to work it out,” says a New York-based rates trader when quizzed on the details.

Ahead of Libor’s demise on June 30, the majority of the US rates market has shifted to overnight SOFR. But large parts of the loan market adopted a term version of the rate, which has a forward element akin to outgoing Libor.

While end-users can hedge this exposure via term SOFR swaps, strict usage guidelines penned by the Alternative Reference Rates Committee (ARRC) mean dealers cannot offset these exposures in the broker market. Instead, they must hedge with overnight SOFR swaps, leaving them to warehouse a basis between the two instruments.

The refinement we put in place relates only to SOFR-term SOFR basis swaps. The ARRC document is super clear

Tom Wipf, Alternative Reference Rates Committee

A recent exemption permitting dealers to trade overnight versus term SOFR basis swaps with buy-side firms may be too narrow to rein in the price differential. This is currently around 2 basis points and likely to grow after June 30, when Libor’s demise will force billions of dollars of loan agreements onto term SOFR via contractual fallbacks.

Now, some banks are eyeing the structured products market as an alternative source to hedge the basis risk.

Structured products allow complex payoffs to be wrapped into a simple note format, where the level of profit or loss varies depending on market movements.

It’s early days, but sources say a potential structure could look something like a reverse steepener note. This would see clients implicitly sell a cap on the basis at, say, 10bp. Investors would receive a coupon up to 10bp and a zero coupon if it widened beyond that – potentially losing some of their investment principal at some point.

This is similar to how some banks offload a pricing differential between yen interest rate swaps cleared at Japan Securities Clearing Corporation and identical instruments cleared at LCH. This basis is packaged into structured notes that are sold to investors in Japan.

The term SOFR basis could also be added as an extra parameter in existing structured products to provide an extra yield pickup for investors.

An alternative approach could see banks package the basis into quantitative investment strategies. This would see the bank create a bespoke index reflecting the price differential then offer a product, such as a note or a swap, that references that index.

Fed's decision

Whether issuance of such products takes place will depend on the proposed structures receiving approval from in-house legal departments and whether enough client demand exists to make it worthwhile. A lot of client education would also be required to get investors comfortable with products linked to this relatively new market parameter.

Yet the biggest hurdle could be regulatory.

At this stage, the ARRC is not inclined to give its blessing for such a structure.

When asked by Risk.net whether banks could use structured products to offload their term SOFR basis risk, Tom Wipf, ARRC chair and vice-chairman of institutional securities at Morgan Stanley, said simply: “No”.

“The refinement we put in place relates only to SOFR-term SOFR basis swaps,” said Wipf.

“The ARRC document is super clear,” he added, reiterating that beyond the narrow carve-out for basis swaps, firms should only be engaging in term SOFR derivatives transactions if they have an underlying interest in a term SOFR cash loan.

Banks considering such trades aren’t convinced the wording is clear cut.

“That one is a question mark,” says an exotics trader at a US bank, responding to the question of whether term SOFR structured products are allowed under the current rules. “I’ve asked it before. It is not clear to me.”

An update of the recommendations, published in April, includes a footnote on the application of the basis swap relaxation, which may shut the door on synthetic positions that provide some form of term SOFR exposure.

“This refinement of the ARRC’s recommendations is limited specifically and solely to term SOFR-SOFR basis swaps. It does not encompass other derivatives trades, for example packaging a term SOFR fixed-floating swap with a SOFR OIS swap to synthetically create a term SOFR-SOFR basis swap,” the footnote reads.

Behind the scenes, some dealers have been quick to note that the ARRC’s usage guidelines are recommendations rather than clear-cut rules. Users of term SOFR derivatives are ultimately governed by licensing terms penned by the rate’s administrator, CME.

CME’s licensing agreement clearly states that structured products are permitted for hedging an existing exposure to term SOFR. Yet this is restricted to end-users with term SOFR loans and regional banks. The agreement also contains a catch-all, requiring licensees to adhere to all ARRC recommendations.

Neither the guidance nor licensing agreement appear to rule out a situation where term SOFR versus overnight SOFR basis swaps are traded with a special-purpose vehicle (SPV), as the recommendations don’t specify the types of counterparty that can trade the swaps. In theory, some say, this could see a bank offload the basis to an SPV, which could then package the exposure into a structured note sold to investors.

Whether the ARRC will allow banks to use structured products to offload basis risk is essentially a matter for the group’s conveners, the Federal Reserve Bank of New York and the Federal Reserve Board. So, if structured notes end up having a role to play in the term SOFR market – or not – it “will ultimately be what the Fed wants,” says one ARRC member.

Without an outlet via structured products, dealers hope that trading in term SOFR versus overnight SOFR basis swaps will provide a ceiling on the basis if it widens sufficiently, by encouraging speculators to enter the market and trade basis swaps.

However, as only the SOFR leg is eligible for clearing at present, traders say the basis may have to move much higher to justify posting two sets of initial margin for the cleared and bilateral legs. Sources indicate the opening of the basis trade has made no real difference to the cost of term SOFR swaps for end-users, which remains stubbornly high.

“There has not been a material improvement since that announcement from the ARRC, in terms of the trading spreads associated with term SOFR,” says Amol Dhargalkar, managing chairman of hedge advisory firm Chatham Financial.

Dhargalkar says it costs borrowers 1–3bp more to purchase a term SOFR swap than the equivalent overnight SOFR swap. Modifying an existing contract, such as a legacy Libor hedge into term SOFR, can cost around 4–6bp, he adds.