SOFR liquidity finally propelled forward?

The long-awaited discounting and price alignment interest (PAI) change from USD Fed Funds (EFFR) to SOFR at the major clearinghouses CME and LCH took place on 16 October 2020. Many market participants see this event as the catalyst that will finally propel SOFR forward as the replacement to USD LIBOR.

The ESTR switch, which happened back in July, was a muted affair and had little effect on the market adoption of the alternative reference rates (ARRs). However, given that EURIBOR will still exist past the end of 2021, this was hardly surprising. The USD switch, in comparison, really should be the tipping point for the USD market. A quick look at USD cleared swaps published by ISDA shows that last week less than 1% were traded referencing SOFR compared to USD LIBOR in both notional terms and number of deals (64 vs 12,909). Year to date that figure is just 0.45%! The USD discounting switch saw record volumes transact in SOFR. At LCH $14.88m DV01 traded on Friday – the previous record was the Thursday leading up to the switch which was $5.57m. For CME 250 outright OIS SOFR swaps traded (similar to the 242 at LCH) but the DV01 was a touch lower $6.7m DV01. Given that volumes tend to drop off in December, November is going to be an interesting month to see if this pickup in liquidity can continue and propel SOFR forwards.

The so-called ‘tough legacy’ contracts and many loan products are still crying out for a term SOFR rate and indeed ARRC has this penciled in on their Paced Transition Plan for the first half of 2021. Liquidity in the derivatives market is critical for this to be possible.

The US Department of Justice gave the green light on October 1st for the ISDA protocol to proceed, confirming that there are no competition issues with the process. ISDA then announced on October 9th that the ISDA fallback supplement and protocol will be launched on October 23, with the effective date of 25 January 2021 and the escrow adherence process open from the launch date for early adherence. This like, the SOFR discount switch, was also a major step forward as assuming everyone signs up and takes advantage of early adherence, any new derivate that is traded will automatically have the proposed fallbacks built-in (SOFR in the case of USD LIBOR).

This means that if you are trading a USD LIBOR swap next year, it is ‘almost’ the same as trading a SOFR swap given the fallback. The reason I write ‘almost’ is because of a comment from the FCA’s Director of Market and Wholesale Policy, who earlier in the summer announced that there was a good chance that the FCA might announce the end of LIBOR before the end of 2020. Such an announcement would be considered a pre-cessation trigger and lead to the “spread” (the 5 year median of the difference between LIBOR and the relevant ARR) being fixed. (The spread compensates counterparties for the fact that LIBOR contains a credit and term premium, whereas the ARR rate does not.)

It was interesting to hear Edwin Schooling repeating his warning at the ACT conference on 14th October 2020, saying:

“Market participants need to be ready for announcements later this year, setting out what will happen at the end of 2021. The scenario that you need to be ready for is that those are announcements of cessation.”

If this is fixed at the end of the year, then there is still a whole year till the end of LIBOR where this spread can be traded in the market. Most people thought that this would be in line with ISDA's announcement on the ISDA protocol and be delayed, given that the protocol was delayed until January 25th, 2021.

Such an announcement would of course cement LIBOR’s fate and make market participants rush to finish their transition programs in time. This would accelerate ARR adoption and market liquidity. What is not yet clear is, if this announcement would apply to all ARRs or perhaps just for the GBP LIBOR replacement.

The FCA and the Bank of England have been further encouraging market participants to switch to SONIA in the interest rate markets. Liquidity providers are encouraged to adopt new conventions for inter-dealer trading based on SONIA instead of LIBOR per the 27th of October. An earlier attempt for this had been set for the 2nd of March.

If successful this time, it should further shift liquidity to SONIA swaps. Swaps referencing SONIA actually already make up 66% of the cleared swaps market last week (and an impressive 56% year to date). Despite Covid concerns and the impact on timelines envisioned before the pandemic struck, these are all positive steps forward and should help propel liquidity in the new ARRs and the replacement of LIBOR at the end of 2021.