SOFR: Farewell to LIBORCME: SOFR ( CME:SR31! )
On June 30th, SEC Chairman Gary Gensler posted a 3-minute short video on Twitter. In this educational piece titled RIP LIBOR, he explains what the London Interbank Offered Rate (LIBOR) is, and why its passing away is actually a good thing for consumers.
As CFTC Chairman in 2009-2014 and SEC Chairman since 2021, Mr. Gensler oversaw the investigation of the 2012 LIBOR scandal and its replacement by the Secured Overnight Financing Rate (SOFR) in 2021 as the benchmark interest rate for US dollar.
Eurodollar and LIBOR
Offshore Dollar, the US currency deposited in banks outside of the United States, is commonly known as Eurodollar. Traditionally, offshore dollars were traded mainly among European banks. The name sticks to these days and applies to funds in non-European banks as well.
A key advantage of trading Eurodollar is the fact that it is subject to fewer regulations by the Fed, being outside of the US jurisdiction. London is the largest trading hub for Eurodollar.
The London Interbank Offered Rate came into being in the 1970s as a reference interest rate in the Eurodollar markets. By 1986, the British Bankers' Association (BBA) began publishing the US Dollar LIBOR daily. The BBA Libor was calculated based on interest rates reported by 17 member banks who together represented the bulk of Eurodollar transactions. Libor has been widely used as a reference rate for many financial instruments, including:
• Forward rate agreements
• Interest rate futures, e.g., CME Eurodollar futures
• Interest rate swaps and swaptions
• Interest rate options, Interest rate cap and floor
• Floating rate notes and Floating rate certificates of deposit
• Syndicated loans
• Variable rate mortgages and Term loans
• Range accrual notes and Step-up callable notes
• Target redemption notes and Hybrid perpetual notes
• Collateralized mortgage obligations and Collateralized debt obligations
How important was Libor? It is a reference rate in the documentation by private trade association International Swaps and Derivatives Association (ISDA), which sets global market standard for OTC derivative transactions.
In 2008, 60% of prime adjustable-rate mortgages and nearly all subprime mortgages were indexed to the USD Libor in the US. Furthermore, American cities borrowed 75% of their money through financial products that were linked to the Libor.
Libor has been the indispensable global benchmark for pricing everything from credit card debt to mortgages, auto loans, corporate loans, and complex derivatives.
CME Eurodollar Futures
In 1981, the Chicago Mercantile Exchange launched Eurodollar futures, the first ever cash-settled futures contract. It quickly became the most liquid contract by CME. At its peak, over 1,500 traders and clerks worked at the Eurodollar pit on CME trading floor.
Not to be confused with the Euro currency, Eurodollar futures contracts are derivatives on the interest rate paid on a notional or "face value" of $1,000,000 time deposit at a bank outside of the United. It uses the 3-month USD Libor rate as its settlement index. The late Fred D. Arditti, CME economist, is credited as the brain behind Eurodollar futures.
Eurodollar futures are priced as a Money Market instrument. The CME IMM index is used to convert a coupon-bearing instrument such as bank deposit, into a discounted instrument that does not make regular interest payments.
For instance, a futures price of 95.00 implies an interest rate of 100.00 - 95.00, or 5%. The settlement price of a Eurodollar futures contract is defined to be 100.00 minus the official BBA fixing of 3-month Libor on the day the contract is settled.
The 2012 LIBOR Scandal
The LIBOR Scandal was a highly publicized scheme in which bankers at major financial institutions colluded with each other to manipulate the Libor rate. As the scandal came to light in 2012, investigators found that the banks had been submitting false information about their borrowing costs to manipulate the Libor rate. This allowed the banks to profit from trades based on the artificially low or high rates.
A dozen big banks were implicated in the scandal. It led to lawsuits and regulatory actions. After the rate-fixing scandal, LIBOR's validity as a credible benchmark was over. As a result, regulators decided that Libor would be phased out and replaced.
If you want to learn more about the LIBOR scandal, feel free to check out the 2017 bestseller by David Enrich: “The Spider Network: The Wild Story of a Math Genius, a Gang of Backstabbing Bankers, and One of the Greatest Scams in Financial History”.
What is the SOFR
In 2017, the Federal Reserve assembled the Alternative Reference Rate Committee to select a Libor replacement. The committee chose the Secured Overnight Financing Rate as the new benchmark for dollar-denominated contracts.
The daily SOFR is based on transactions in the Treasury repurchase market, where firms offer overnight or short-term loans to banks collateralized by their bond assets ,similar to pawn shops.
Unlike LIBOR, there’s extensive trading in the Treasury repo market, estimated at $4.8 trillion in June 2023. This theoretically makes it a more accurate indicator of borrowing costs. Moreover, SOFR is based on data from observable transactions rather than on estimated borrowing rates, as was the case with LIBOR.
The Federal Reserve Bank of New York began publishing the SOFR in April 2018. By 2021, SOFR has replaced most of the LIBOR-linked contracts. The LIBOR committee officially folded up on June 30, 2023. Chairman Gensler apparently chose this day to post his RIP LIBOR video to mark the end of an era.
The difference between Fed Funds Rate and SOFR
Fed Funds Rate is set by the Fed’s FOMC meeting, and SOFR is published by the NY Fed. However, they are very different.
• Fed Funds Rate is considered a risk-free interest rate, and only member banks have access to this ultra-low rate through the Fed’s discount window.
• SOFR is a commercial interest rate where banks charge each other. The NY Fed publishes the rate based on transactions in the US Treasury repurchase market.
SOFR is similar to LIBOR because they are both commercial interest rate benchmarks. On the other hand, Fed Funds Rate is a policy rate set by the US central bank.
CME SOFR Futures and Options
CME Group launched the 3-month SOFR futures and options contracts in May 2018. The contracts were based on the SOFR Index, published daily by the New York Fed.
SOFR futures contracts are notional at $2,500 x contract-grade International Monetary Market (IMM) Index, where the IMM Index = 100 minus SOFR. At a 5.215 IMM, for example, each contract has a notional value of $13,037.50. CME requires a $550 margin per contract. An interest rate move by a minimum tick of 0.25 basis point would result in a gain or loss of $6.25.
At the beginning, SOFR contracts traded side-by-side with the Eurodollar contracts. By 2021, Eurodollar liquidity has transitioned to SOFR contracts. By April 2023, All Eurodollar contracts were delisted, and the transition was completed.
For all intended purposes, you could think of the SOFR futures as the same as the legacy Eurodollar contracts, with the only notable exception being the settlement index switched from LIBOR to SOFR.
On June 30th, the daily trading volume and Open Interest of SOFR contracts were 4,443,245 and 9,310,433 contracts, respectively. On the same date, CME Group total volume and OI were 23,769,103 and 104,221,083, respectively.
On the latest trade day, SOFR accounts for 18.7% of CME Group’s trade volume and 8.9% of its total open interest. Indeed, SOFR has successfully replaced Eurodollar as new No. 1 contract at CME and is arguably the most liquid derivatives contract in the world.
Where We Are at the SOFR Market
On June 30th, the JUN SOFR contract (SR3M3) expired and settled at 94.785. This translates to the JUN SOFR rate of 5.215 (100-94.785).
SEP 2023 (SR3U3) is now the new lead contract. It settled at 94.595 and implied a forward SOFR rate at 5.405 (100-94.595). This shows that the futures market expects a rate increase in the next Fed meeting.
Like Eurodollar futures, rising futures price will confer to declining SOFR rate, as rate is equal to 100 minus futures price. Similarly, a decline in futures price equates to a rising SOFR rate.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
SOFR
Sovereign Debt Crisis - Cracks Showing in the Yen?Long position on OANDA:USDJPY
Interest rates on US dollars are rising globally, at a very rapid rate. Capital has been flowing towards the United States for the last couple years, as a global flight to security occurs as fear rises in markets during times of turmoil.
Because the US Dollar is the reserve currency of the globe, debts backed by US Treasuries are quickly becoming expensive - particularly for sovereigns. Sovereign debt, particularly long-tenor notes and bonds, have demonstrated to be very illiquid in the last decade. Globally, central banks have attempted to combat this issue with lower interest rates and quantitative easing.
This theory, however is fundamentally flawed since it does not address the lack of price discovery in these markets. Central banks can support these markets domestically, but without a foreign buyer they hold little value, and the currency will experience inflation relative to other currencies. In this instance, this is the US Dollar. See this chart of the British 10-Year Bond (Gilt) Futures, where there was a panic in the market a few months ago as pension funds holding large quantities of Gilts were rendered insolvent. The same pattern can be observed on a USDGBP chart, as capital fled the nation and its debt lost value (rates rise).
The crisis that nations now face, is that they are burning the candle at both ends. Japan has been employing strict interest rate controls, and extraordinary liquidity-providing measures to domestic banks for decades to stimulate inflation. In the past couple months however, they have begun to employ currency controls, to curb the loss of value of the Yen in FX markets. Despite this inflation they have had little success stimulating growth domestically. Negative rates reflect a negative demand for sovereign debt, as if the entity "buying" it must be paid to do so.
Rates have also gone negative in Europe, see the financial capital, Germany, has struggled since 2009 to find a market for its debt. US banks are reluctant to lend via repo to European banks for their sovereign entities possess such great risk
The Reverse Repo facility (RRP) has become a black hole for capital around the globe. During QE it offered the highest return on cash for money-market funds and other money market participants. As rates rise globally, so too does risk. As markets like Europe are unable to keep up with the rise in rates as is occurring in the United States, so capital will continue to flee these nations under duress and create a feedback loop. The RRP is a zero-risk investment, so offers a safe home for flighty capital looking to liquidate long-term debt. See chart of Yen, inverse Euro and RRP usage
The Bank of Japan has become unable to control the market on its 10-year debt security, and it will continue to rise and push against the imaginary "ceiling" imposed on it, until a currency crisis occurs and a crisis in sovereign debt markets may begin to be realised.
Capital will flow very quickly towards the United States in this event. Since it is the financial capital of the world still, as it is the reserve currency of most foreign governments, any assets priced in US dollars will grow in value. Particularly equities, this will be a theme in markets over the following years. War in Ukraine will continue to create massive inflationary pressure globally, as capital concentrates around a very expensive and complicated geopolitical conflict. Rates will continue to rise until this is resolved, and sovereign debt will quickly become un-affordable as the price falls due to rate increases. Debt is already concentrating in short-term debt markets, like REPO, FIMA, SOFR and so on. Pension and mutual funds will quickly be rendered insolvent as they are the parties which hold gigantic quantities of these dangerously illiquid bonds.
BEWARE of these markets, they are a ticking time bomb and all global currencies have a massive exposure.
SOFR Futures Curve
SOFR (Secured Overnight Financing Rate) is a benchmark interest rate that is based on the cost of borrowing cash overnight, collateralized by US Treasury securities. It is considered to be a replacement for the LIBOR (London Interbank Offered Rate) benchmark, which is being phased out by the end of 2021. SOFR futures are derivative contracts that allow market participants to trade on the expected future values of the SOFR rate. They are traded on the Chicago Mercantile Exchange (CME).
SOFR futures prices are quoted in terms of the expected SOFR rate at the time the contract expires. For example, a SOFR futures contract expiring in March 2023 may be quoted at a price of 98.50, which would imply an expected SOFR rate of 1.50% at that time. These prices are used by market participants to hedge against interest rate risk and to speculate on the future direction of interest rates.
The importance of SOFR futures lies in their use as a benchmark for a wide range of financial products, including loans, mortgages, and derivatives. As such, movements in SOFR futures prices can have significant implications for the broader financial markets. Traders and investors can use charts of SOFR futures prices to identify trends and patterns in the market and to make informed trading decisions. The ability to analyze and interpret these charts is therefore a valuable skill for anyone involved in the financial markets.
Futures curves are a series of futures contracts for a specific underlying asset with different delivery dates. The SOFR futures curve represents the market's expectation of future SOFR rates over time. It shows the current market pricing for SOFR futures contracts with different maturities. Each point on the curve represents a future SOFR contract with a specific expiration date.
Reading the SOFR futures curve can provide important insights into market expectations about the future path of interest rates. The shape of the curve can provide signals about market sentiment and economic conditions. In a typical yield curve, a steep upward slope suggests the market expects interest rates to rise in the future, while a flat or inverted curve suggests the opposite. The same principles apply to futures curves.
The SOFR futures curve is particularly important for markets as it serves as a benchmark for pricing various financial products, such as swaps and interest rate derivatives. Changes in SOFR futures prices can have a significant impact on the broader financial markets and the economy as a whole. As such, traders, investors, and policymakers closely monitor the SOFR futures curve to gain insights into the market's outlook for interest rates and to inform their investment and policy decisions.
