SOFR basis blows out amid CCP discounting changes

Rate cuts may have exacerbated discount risk as basis swap opt-outs move deeply in-the-money

dollar cut

The price difference between longer-dated interest rate swaps benchmarked to the secured overnight financing rate (SOFR) and the effective federal funds rate (EFFR) has tripled since mid-June.

At 30-year maturities the SOFR-EFFR basis jumped from two basis points on June 15 to a high of 7.8bp on July 21, according to Bloomberg data. The basis now sits at 6bp.

Interest rate strategists say the widening is likely a result of dealers and hedge funds positioning for an expected spike in the SOFR-EFFR basis ahead of October’s “Big Bang” discounting switch at clearing houses. The moves may also have been exacerbated by emergency rate cuts, which have amplified discounting risk by pushing many receive-fixed trades held by asset-liability managers deeply into the money. Some are “re-couponing” these trades to reduce their discount risk – another possible tailwind for recent shifts, strategists say.


“This is a trade that has been talked about for a while,” says Subadra Rajappa, head of US rates strategy at Societe Generale. “There could be hedge funds doubling down on positions as they’re seeing a steady stock of asset-liability management (ALM) flows, while there is also flow from the dealers.”

CME and LCH, the two largest clearing houses for US dollar interest rate swaps, will begin using SOFR to calculate the value of future cashflows and the interest paid on collateral – known as price alignment interest (PAI) – for US dollar swap contracts from October 19. Currently, EFFR is used for discounting and PAI.

This development is part of the market’s transition from US dollar Libor to SOFR, the Federal Reserve-backed alternative reference rate.

CME and LCH are set to kick off the transition from October 16. Valuations from the two different benchmarks will differ, meaning there will be a change to swapholders’ net present value (NPV). To account for this, the two central counterparties (CCPs) will compensate participants with a one-off cash adjustment to their margin accounts.

But the move to SOFR also introduces a change in risk profile for these cleared swaps. To compensate, CME will book mandatory SOFR-EFFR basis swaps to client accounts, which can then be unwound at an auction. LCH is allowing clients to opt out of these basis swaps and elect for cash-only compensation instead, but will hold an auction process for unwanted basis swaps ahead of the switch.

Portfolios with positive NPV would be compensated with the receive SOFR/pay Fed funds leg of basis swaps, while holders of portfolios with negative NPV would get the opposite – pay SOFR/receive Fed funds. The volume of basis swaps paid out depends on the level of NPV, or “moneyness” of the portfolio; those with extreme positive or negative NPV would receive a larger number of basis swaps, while those around par would receive fewer.

Preparing for “tighteners”

Dealers and speculators are now trying to second-guess which institutions will decline to take these swaps onto their books and instead submit them for auction. After opposite legs have been netted down, the residual of unwanted swaps would determine the direction of the basis.

“If you think only insurance companies are likely to opt out of these basis swaps, then that means the SOFR-EFFR basis should be higher. If you think only asset managers are going to opt out, it likely has the opposite implication,” says Joshua Younger, head of US interest rate derivatives strategy at JP Morgan. “These are all the questions people are trying to figure out, and I think that's what’s driving volatility in the basis.”

Recent widening at the long-end suggests expectation that ALM businesses, such as insurers and pension funds, will ditch their basis swaps.

These end-users dominate the 30-year swap market with one-way, receive-fixed flow – most of this is now heavily in-the-money since the Federal Reserve slashed policy rates by 150bp. It means these clients would be issued with a high volume of receive SOFR/pay Fed funds basis swaps.

If you think only insurance companies are likely to opt out of these basis swaps, then that means the SOFR-EFFR basis should be higher

Joshua Younger, JP Morgan

Many of these institutions are unable to hold basis swaps on their books under their derivatives use plans (DUPs), meaning auctions at both CCPs could be full of receive SOFR/pay Fed funds flow – so-called “tighteners” that gain in value as the gap between the two rates narrows.

Asset managers, which tend to be skewed towards pay-fixed swaps, may also choose to ditch their basis swap compensation. While this may offset some of the ALM flow, strategists say lower NPVs and more balanced portfolios mean the number of basis swaps being offloaded by the group is unlikely to neutralise discounting risk from insurers.

“Rates have gone down, so the amount of risk to clear at the auction has gone up by a factor of two, possibly more,” says JPM’s Younger.

He adds that relative value hedge funds cannot be relied upon to take the other side of these auctioned trades, as they were at the epicentre of losses in March.

“You have the situation of relying on a population of investors who have been dealing with a very disruptive environment to place a multiple of the risk you thought you’d have to place, and that's a vicious cycle-type setup.”

Banks expecting a flood of receive SOFR/pay Fed funds tightener swaps at auction are seeking to maximise value by securing them at the widest possible level. Many are positioning in the run-up to the big bang by putting on new trades that pay SOFR and receive Fed funds – forcing the basis wider, says Rajappa.

“You’re expecting SOFR rates to go lower and Fed funds rates to go higher. Or even if SOFR stays the same, and the Fed funds rate goes higher, the basis net is going to be wider,” she says. 


Participants have ramped up activity in the longer-dated SOFR swap market ahead of the CCP switch, says Richard Chambers, global co-head of short-term macro trading at Goldman Sachs. Speaking on a webinar hosted by the Federal Reserve Bank of New York on July 22, he said there has been a significant jump in DV01, or the amount of risk traded, in June and July.

“As we approach the October event, we have seen more activity in back-end SOFR trading, both in the basis and outright rates,” he said. “The telling change in the markets has been an increased participation of end-user client base who traffic in the back end of the derivatives market and we continue to expect more of that to happen over the summer months.”

These end-users are thought to be insurance firms and pension funds “re-couponing” swaps they have on their books to reduce their discount risk, strategists say. This involves converting legacy receive-fixed swaps, which are heavily in-the-money, into new trades with at-market fixed coupons and monetising the difference.

The activity lowers the net present value (NPV) of positions, thereby reducing the compensation requirement and the number of basis swaps that may need to be issued.

“You will still have basis swap risk, but it will be much smaller in magnitude because you don't have as big P&L to manage when the PAI and discounting transition occurs,” says Priya Misra, global head of rates strategy at TD Securities.

The activity also results in unwinding of EFFR/Libor basis swaps used to hedge the discount risk. Strategists say this may be contributing to the SOFR/Fed funds widening trend, given that the Libor/SOFR basis is anchored to swaps fallbacks, creating a mechanical relationship between the three rates.

Auctions are taking place on October 16 at LCH and October 19 at CME. The market will learn more about which institutions opt out of these basis swaps prior to this. CME clients must make their elections by October 2, while at LCH, end-users must inform the clearing house of plans to opt out by September 4. LCH will publish an indicative size of the auction portfolio by September 18, potentially driving more ructions in the basis market.

“If we know that there's a lot of people opting out, the basis market is likely to move on that day,” says Misra.

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