Progress has been made on fallbacks to adjust for structural differences during the Libor transition.
SOFR swap trade volumes have picked up significantly this month as trades in just one week were half of the combined May and June totals according to Clarus Financial Technology, the derivatives analytics provider.
The secured overnight financing rate, SOFR, has been adopted by the US as its risk-free rate to replace US dollar Libor.
After the financial crisis there were a series of scandals regarding banks manipulating their submissions for setting benchmarks across asset classes, such as Libor, 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 UK Financial Conduct Authority said two years ago that it will not compel panel banks to submit to Libor beyond 2021.
USD SOFR Swaps volumes on the up in Aug 2019 https://t.co/ZXGdvG9Cpd pic.twitter.com/9xj7abdad9
— Clarus (@clarusft) August 14, 2019
Amir Khwaja, chief executive of Clarus Financial Technology, said on the firm’s blog that 37 trades in outright SOFR overnight indexed swaps were reported in the week beginning August 5, which is 50% of the trade volumes in May and June combined. In addition, there were 17 trades in SOFR basis, which is also 50% of the volume in the whole of May and June.
Khwaja continued: “Based on outrights as off a swap execution facility and basis as on SEF, we can assume that currently customer activity is in outrights and hedging in the dealer market is in basis. Sounds logical in the evolution of a new market.”
Regulators have been urging the financial industry to begin transitioning to the new risk-free rates without waiting for term rates to be fully developed. For example, this month John Williams from the NY Fed said market participants should begin using SOFR as soon as possible.
SOFR term rates are being developed but the industry cannot wait for them to transition from #LIBOR, says @NewYorkFed's John Williams.
Watch our conversation → https://t.co/PzjRYjesMd pic.twitter.com/VxId59j6My
— SIFMA (@SIFMA) August 6, 2019
In addition Sifma, the securities industry trade body, and the Bank of England sent letters to chief executives on the Libor transition:
The June 2019 Dear CEO letter we sent w/ @bankofengland was a very clear message that the transition to alternative reference rates must be on a firm's senior executive agenda, says @TheFCA CEO Andrew Williams.
Watch him explain → https://t.co/PzjRYjesMd #LIBOR #SONIA #RFRs pic.twitter.com/owBSqWCh5y
— SIFMA (@SIFMA) August 14, 2019
Transition progress
ISDA, the derivatives trade association, said in its quarterly magazine this month that the latest consultation on transition from Libor has closed, so work can be done on finalising and implementing changes into derivatives contracts and reducing the systemic risk of a market disruption.
The latest issue of IQ (ISDA Quarterly) is now available. Read the magazine here https://t.co/REypDTfgSW
— ISDA (@ISDA) August 5, 2019
“Market feedback has now been sought on nine key IBORs in total, including US dollar Libor,” added ISDA. “As with the first consultation last year, the latest asked market participants to opine on possible methodologies to adjust for structural differences between the IBORs and the risk-free rates (RFRs) that will replace them if a fallback is triggered.”
ISDA continued that definitions are expected to be amended before the end of the year and a protocol will be developed to enable firms to adapt legacy derivatives contracts.
“The progress made on fallbacks is critical – and the end is in sight,” said ISDA. “This is a big step towards ensuring derivatives markets are safer and more efficient by ensuring a robust backup is in place if an IBOR permanently ceases to exist.
This month ISDA said it had selected Bloomberg Index Services Limited to calculate and publish adjustments related to fallbacks that ISDA intends to implement for certain interest rate benchmarks.
However the association also warned that an enormous amount of work is needed to shift the market away from its use of Libor and other IBORs and to develop trading activity and liquidity in the alternative RFRs before the end of 2021.
“A consultation on adjustments to the fallback for euro Libor and Euribor will be held after the alternative RFR for euro, €STR, is published in October,” said ISDA. “Given the adjusted fallback will not match the relevant IBOR exactly – meaning there will be winners and losers if the fallback is triggered – voluntary adoption of RFRs before any permanent cessation of an IBOR will be the preferable route for many.”
