Trading in futures and options based on risk-free rates have reached record volumes as regulators have been warning about the approaching deadline at the end of this year when a number of Libor rates will cease to exist.
CME Group said that its SOFR futures contracts reached a record of more than one million contracts of open interest on September 15. SOFR futures open interest reached 1,004,882 contracts marking its seventh consecutive record open interest day.
#SOFR futures open interest surpasses 1 million contracts.
— CME Group (@CMEGroup) September 16, 2021
After the financial crisis there were a series of scandals regarding banks manipulating their submissions for setting benchmarks across asset classes, which led to a lack of confidence and threatened participation in the related markets. As a result, regulators have increased their supervision of benchmarks and want to move to risk-free reference rates based on transactions, so they are harder to manipulate and more representative of the market.
The US Alternative Reference Rates Committee (ARRC) selected SOFR to replace US dollar Libor, although other new reference rates have also been launched.
If firms use a rate other than SOFR, they need to do extra work to show they are making a reasonable decision, and they will be asked about that decision, says Michael Held @NewYorkFed #isdabenchmarks @ISDAConferences
— ISDA (@ISDA) September 15, 2021
On June 8 a subcommittee of the US Commodity Futures Trading Commission recommended a “SOFR First” initiative in which interdealer brokers replaced trading of Libor linear swaps with SOFR linear swaps from July 26 this year.
Agha Mirza, CME Group
Agha Mirza, global head of rates and OTC products at CME Group, said in a statement that the group was pleased with the adoption of CME SOFR futures since they were introduced nearly three and a half years ago.
“This milestone is reflective of the strong growth we’ve seen throughout the SOFR ecosystem since CME implemented SOFR-based fallbacks on March 29 of this year,” Mirza added. “In August, SOFR futures volume increased 195% year over year to 125,000 contracts per day and our over the counter SOFR swaps volume rose to $65bn in notional volume cleared.”
SOFR-linked open interest, which includes open interest in SOFR futures and options plus any Eurodollar futures and options open interest beyond June 2023, has increased to 20.2 million contracts since the adoption of SOFR-based fallbacks. This accounts for more than a third, 38%, of total short-term interest rate futures and options open interest at CME Group.
Sonia derivatives
The UK has chosen Sonia as the risk-free rate to replace Libor.
On 16 September Sonia options reached a record volume of 620,826 contracts at ICE and just over one fifth, 21.8%, of sterling futures & options are now in Sonia at ICE.
Record volumes yesterday in SONIA options of 530,850 contracts, and in SONIA futures & options of 648,695.
SONIA futures & options open interest hit over 1.8M.
21.8% of Sterling futures & options is now in SONIA.
— ICE (@ICE_Markets) September 16, 2021
Steven Hamilton, global head of financial derivatives at ICE, said in an email: “The rapid increase in trading of Sonia contracts reflects increased market activity in risk free rates ahead of Sterling Libor cessation at the end of 2021. We have worked closely with our customers to provide them with the tools they need to manage sterling interest rate risk and the transition from Sterling Libor.”
Progress on Libor transition
The increasing trading activity in risk-free rates derivatives was cited as a response for optimism by Scott O’Malia, chief executive of ISDA, in a Benchmark Strategies Forum on 15 September.
Scott O’Malia, ISDA
“Trading activity in derivatives linked to alternative rates has been steadily climbing in recent months, and we expect that to continue as we get nearer to the end-2021 deadline,” he said.
However, he also warned that it was just 108 days, a little over three months, until 30 Libor settings either cease to exist or become non-representative and there is still work to do to transition legacy Libor contracts to alternative rates ahead of the deadline.
The UK Financial Conduct Authority said in March this year that Libor settings will either cease to be provided by any administrator or no longer be representative immediately after 31 December 2021 for all sterling, euro, Swiss franc and Japanese yen settings, and the one-week and two-month US dollar settings. The remaining US dollar settings will end immediately after 30 June 2023.
O’Malia continued that following the introduction of the SOFR First initiative, trading activity in SOFR reached 12.5% of total cleared US dollar interest rate derivatives DV01 in August versus 7.4% the previous month according to analysis by ISDA and Clarus Financial Technology, the derivatives analytics provider.
ISDA-@clarusft Risk-free Rate (#RFR) Adoption Indicator increased to an all-time high of 17.5% in August compared to 14.1% the prior month. Interested in learning more key highlights for August 2021? Read the full report here: https://t.co/PazT5rHclU pic.twitter.com/wcJOjMxtDf
— ISDA (@ISDA) September 14, 2021
He expects several upcoming milestones should spur progress.
The UK’s Working Group on Sterling Risk-Free Reference Rates has set a target of the end of this month for firms to complete active conversion of all legacy sterling Libor contracts expiring after the end of 2021 where viable.
In December the major central counterparties will convert all existing cleared swaps linked to euro, sterling, Swiss franc and yen Libor to RFR overnight index swaps which O’Malia said will eliminate a vast amount of legacy Libor exposures at a stroke.
Phase II, also known as #RFR First, will be our next milestone. On Sept 21, the interdealer market will switch trading conventions from #LIBOR to #SOFR in cross-currency swaps, which includes those referencing US dollar, sterling, Swiss franc and Japanese yen, says @CFTCbehnam
— ISDA (@ISDA) September 15, 2021
“For those non-cleared derivatives that remain, robust fallbacks will automatically take effect in the vast majority of cases if firms don’t complete their transition efforts in time,” he added. “So far, more than 14,500 entities across nearly 90 jurisdictions have adhered to ISDA’s IBOR Fallbacks Protocol, which incorporates the fallbacks into existing non-cleared derivatives.”
O’Malia concluded there has been good progress on legislative solutions for tough legacy exposures.
The UK Financial Conduct Authority has completed a consultation on its policy framework for the development of a synthetic Libor for certain settings, and is shortly expected to consult on the specifics of who will be able to use synthetic Libor for six sterling and yen Libor tenors.
In the US the House Financial Services Committee passed a bill on July 29 to resolve tough legacy positions tied to US dollar Libor, following the passing of similar New York state legislation passed in April.
By the end of this year, every firm needs to have stopped using LIBOR for all new exposures and landed safely on robust alternatives – that’s not a recommendation but explicit supervisory guidance, says Michel Held @NewYorkFed #isdabenchmarks
— ISDA (@ISDA) September 15, 2021
“Five of the most popular US dollar Libor settings will continue to be published until mid-2023, giving firms a little more wiggle room to deal with legacy US dollar Libor trades,” O’Malia said. “However, a number of regulators across the globe, including the Federal Reserve, have said they will restrict new use of US dollar Libor from the end of 2021, except in limited circumstances.”
O’Malia said there is no room for complacency over the next 108 days. He said: “We must use the remaining time wisely to ensure everyone is ready for a future without Libor.”
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