We explore the current status of the SOFR derivatives markets and review whether the market is ready for a Term SOFR benchmark.
- The intention is for Term SOFR, a rate to be available during the first half of 2021, if there is sufficient liquidity, to be a USD LIBOR replacement.
- While there has been a positive trend in the adoption of SOFR derivatives over 2020, this is off a very low base.
- The data indicates the best way forward is to defer the publication of Term SOFR benchmark beyond H1 2021.
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In September 2020, the Alternative Reference Rates Committee (ARRC) released an RFP to select a benchmark administrator to calculate and publish a forward-looking SOFR term rate (“Term SOFR”).
As per the previously released ARRC 2020 Objectives, the RFP reiterated the ARRC’s intention for such a rate to be available during the first half of 2021, if liquidity in SOFR derivatives had sufficiently developed.
In this blog, we explore the current status of the SOFR derivatives markets and review whether the market is ready for a Term SOFR benchmark.
Alternative input sources
There are two viable instruments from which a Term SOFR rate can be derived:
- Futures
- Overnight Index Swaps (OIS)
SOFR futures are traded on an exchange and specify the average SOFR rate for delivery at various dates in the future. The organised structure of an exchange facilitates the data collection.
Given the expiry dates of the futures do not perfectly align with the tenors of the Term SOFR benchmark, a model needs to be adopted to estimate the rate for each tenor of the benchmarks (e.g. 1-month, 3-month, 6-month, 12-month).
This model requires strong assumptions to be made, such as interest rates remaining constant between FOMC dates, which do not always hold true in the real world and can cause inaccuracies in the rate.
OIS have historically traded in OTC markets with execution taking place on a combination of voice-brokered and electronic venues. The latter facilities better capture of data.
Unlike futures, OIS don’t trade with fixed expiry dates but trade in fixed tenors that align with benchmark tenors (e.g. 1-month, 3-month, 6-month, 12-month). For this reason, no complex model is required in the calculation of a Term SOFR benchmark based on OIS.
Avoiding the complexity of a model and the strong assumptions is preferable as the benchmark calculation is simpler and has fewer potential sources of error. It is for this reason that the majority of market participants interviewed by Refinitiv on Term SOFR prefer a rate based on the OIS market.
Before concluding that an OIS based methodology would be preferable to that of futures, one needs to consider the market liquidity in both instruments and determine whether either market is liquid enough to create a robust benchmark.
Watch: What is LIBOR? – The Big Explainer – Refinitiv
Market adoption of SOFR derivatives
While there has been a positive trend in the adoption of SOFR futures over 2020, this is off a very low-base and the vast majority of activity, over 90 percent of contracts traded, remained concentrated in LIBOR as of the end of 2020.
Similarly, there has been a positive trend in the adoption of SOFR OIS, but again this is also from a low base. As shown below, data from the DTCC trade repository shows that during 2020 the proportion of spot starting USD OIS trades with maturities between 1 and 12 months grew from around 5 percent in January to greater than 15 percent in November.
Defer term SOFR launch
Clearly, further progress is required in terms of the transition of liquidity away from USD LIBOR and towards SOFR before a truly robust Term SOFR benchmark can be created.
In the event a Term SOFR benchmark is released prior to the development of sufficient liquidity, it risks potentially an unsuitable benchmark being introduced and a poor quality rate could inhibit adoption in the market.
The data indicates the best way forward is to defer the publication of Term SOFR benchmark beyond H1 2021.
During this period, liquidity in SOFR derivative markets will grow, driven by more firms adapting their infrastructure to support the overnight risk free rate, and market structure will continue to favour electronic trading over voice.
Furthermore, the likely cessation date of the major USD LIBOR tenors is 30 June 2023, meaning that there is plenty of time for SOFR liquidity to develop and for firms to adopt a new Term SOFR benchmark prior to USD LIBOR cessation.
Clearly further work is required to think through how an extension to the Term SOFR publication date would interact with interim LIBOR transition milestones, but the basic principles are sound.
