Jumbo SOFR swaps herald new world of repo betting

Swaps traders told to “learn repo market dynamics” as market catches glimpse of new trading strategy

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A $6 billion interest rate swap that hit the market this week – and was quickly followed by a $3 billion trade – suggests traders are starting to explore opportunities created by the rates world's newest benchmark, the US secured overnight financing rate, or SOFR.

Because the benchmark is a blend of three different repo rates, SOFR swaps could now be used to hedge or exploit repo market moves – and swaps traders will need to be more aware of potential feedback between the markets.

“It’s an interesting trade that highlights the potential of SOFR and the new possibilities it brings, but also shows some idiosyncratic aspects of that reference rate that might be a little hard to understand for non-experts and end-users,” says a US swaps trader at one dealer.

A New York-based rates trader at a large asset manager concurs: “Some people are going to want to bet on the repo market, and there’s certainly an opportunity for them to get involved.”

The first of the two trades – a non-cleared, off-platform swap – was executed on March 18 with a fixed rate of 3.05%. That is around 50 basis points higher than most of the 116 swaps that have been executed since the first transaction last July. It is set to go live on March 29 and expire three days later on April 1, covering a period in which SOFR is expected to rise due to quarter-end funding pressures.

The trade is also by far the largest SOFR swap executed to date in notional terms. At the point it traded, the fledgling market had only seen a total of $18.4 billion in volume, according to data published by the International Swaps and Derivatives Association. But while it was a very large transaction by notional, the asset manager says it was “minuscule” in risk terms, with a DV01 of only $5,000, the change in valuation per basis-point move in the benchmark.

Nevertheless, should SOFR climb at the end of the quarter, like it did on December 31, it could make the trader – which market participants believe was a hedge fund either speculating or hedging rising quarter-end repo costs – a decent profit. SOFR is currently trading at 247bp, according to data published by the Federal Reserve Bank of New York.

“It’s a bet on the chance that repo spikes over quarter-end because of the various balance-sheet constraints the banks have,” says the asset manager’s rates trader.

A further $3 billion trade was recorded two days later across the same dates, at a slightly higher rate of 3.1%, which traders speculate was either the original dealer paying up to hedge its initial exposure, or its client adding to the position.

Repo rate spikes have been common at year-end since 2016, when the Federal Reserve’s risk-based capital surcharge for global systemically important banks came into force, but traders seeking to make money on those moves have so far sought to do so in the repo market itself – using repo-indexed swaps is a new trade.

US banks tend to step out of the market on the last trading day of the year, when regulators take a snapshot of their books to calculate the following year’s capital surcharge, but traders at JP Morgan took advantage at the year-end, adding $101 billion to the bank’s repo book in the fourth quarter.

The volatility has been present at quarter-ends, too. French banks have become some of the biggest players in the US repo market in recent years thanks to regional differences in the way the leverage ratio is applied.

Under European rules, banks are required only to calculate a snapshot of their leverage exposure at the end of the quarter, meaning they trade a lot of repo during those months before slashing their balance sheet in the final days of the quarter. March 29 is expected to be no different, say traders.

But this new swap trade means there are some in the swaps market beginning to understand the idiosyncrasies of the repo market, say the traders. One rates strategist says this will be important as SOFR swaps develop.

“Derivatives market participants are going to have to learn repo market dynamics, and that’s something that in the past your average swap trader wouldn’t know. Repo is its own little fiefdom in the financial world and you’re going to have to understand it better versus Libor,” he says.

Additional reporting by Lukas Becker and Ben St. Clair