Tradition to launch first SOFR order book

Streaming swap prices are a critical step to creating term rates for loan markets

Spotlight on SOFR

Exchange-style trading of swaps linked to the secured overnight financing rate, or SOFR, is set to begin on March 22, when interdealer broker Tradition plans to make them available to trade on its Trad-X platform.

SOFR swaps are currently traded via voice and request-for-quote (RFQ) protocols. The availability of continuous streaming liquidity on electronic central limit order books (Clobs) is seen as a crucial step towards shifting the market away from US dollar Libor benchmarks. That could take some time to develop, though – Trad-X’s SOFR order book will initially feature firm, two-way prices entered by Tradition’s voice brokers and ad hoc quotes from banks looking to test the infrastructure.   

Stuart Giles, managing director for strategy and business development at Tradition, says the market was caught in a “chicken-and-egg” situation. “Do you wait until the streamers are ready or do you create the order books? Our voice desks are fairly busy on SOFR at the minute, so we think it makes sense to create the order books now.”

Streaming two-way dealer prices for standard SOFR swaps may still be some months away. But liquidity is starting to build in some corners of the market, such as SOFR versus Fed Funds basis swaps. These contracts have been heavily traded since October 2020, when clearing houses switched the rate used to discount future cashflows from Fed funds to SOFR.

“Dealers have the ability to price these things now. We can see that because they make us prices on voice all the time,” says Giles. “If they have the pricing tools, they’ve worked out how to calculate this and all they’ve got to do is join it to their streaming technology.”

Sluggish liquidity in SOFR swaps was a key factor in the decision to delay US dollar Libor’s retirement until at least June 2023. Libor benchmarks for all other currencies, including sterling, will be discontinued at the end of this year.  

SOFR represented just 3% of US dollar swap volume during the fourth quarter of 2020, according to data compiled by the International Swaps and Derivatives Association.

The Alternative Reference Rates Committee, the Federal Reserve-backed group tasked with steering the market away from Libor, warned at a meeting in February that poor liquidity in SOFR swaps would impede plans to recommend and publish a term SOFR rate by June 2021 – a key milestone in the ARRC’s transition plan.  

While most products will use compounded-in-arrears versions of SOFR when Libor is discontinued, forward-looking term rates derived from swap quotes will be the primary fallback for some cash instruments, including floating rate bonds, bilateral business loans, syndicated loans and securitisations.

These are all pieces of the jigsaw that allow you to move away from Libor

Stuart Giles, Tradition

The UK’s Financial Conduct Authority was instrumental in getting dealers to quote firm Sonia prices on electronic Clobs operated by Tradition, TP Icap and BGC Partners. The first regulated Sonia term rates based on these quotes went live in January.

When contacted by Risk.net, TP Icap and BGC Partners declined to say whether they planned to add SOFR swaps to their Clob platforms.

Giles says it took the better part of a year to build liquidity in its Sonia order book. An average of six dealers now stream two-way Sonia swap quotes in one-month to 30-year maturities on Trad-X at any given time.  

US regulators have taken a more hands-off approach. A May 2020 paper from the ARRC on best practices for transition called on dealers to begin electronic market-making and execution in SOFR swaps by September 30, 2020. That deadline was roundly ignored and there has been no further word from regulators or the ARRC.

“Regulators in the US have been much quieter compared to regulators in the UK. It seems to be a very different approach and it’s going to have to be industry driven. But commercial banks in the US want a term rate, so it should be like pushing on an open door,” says an industry consultant. 

Non-linear dynamics

Streamed SOFR quotes are also a vital input for the Ice Swap Rate – a measure of term swap pricing from one to 30 years.

The Ice Swap Rate, formerly known as IsdaFix, is widely used to calculate settlement values in the $40 trillion interest rate options market. It is also an input for constant maturity swaps, which underpin the majority of rates structured products, such as range accruals.

In the absence of a term swap benchmark, exotics desks must rely on dealer polling or use the last available fixing to price instruments such as cash-settled swaptions. Traders had to resort to these techniques when Clob pricing evaporated during the Covid-19 turmoil in March last year. Ice Benchmark Administration (IBA) is using back-up RFQ data from dealer-to-client platforms to address the problem, but a new SOFR version of the Ice Swap Rate built on a foundation of Clob data will be required to transition options and structured products from Libor.     

“These are all pieces of the jigsaw that allow you to move away from Libor,” says Giles. “For example, without a SOFR Ice Swap Rate, the option market is going to stay on Libor because you don’t want to phone around six banks every time you have an option settlement to work out if it’s in-the-money or out-of-the money. You just want to go and look at a reference rate.”

IBA began publishing a Sonia version of the Ice Swap Rate last October. A taskforce of the sterling risk-free rate working group is currently consulting on a fallback methodology for non-linear products, which would see contracts relying on the sterling Libor Ice Swap Rate re-hitch to the Sonia version plus an additional spread adjustment at the end of this year.

IBA is closely monitoring liquidity in SOFR and is planning to work with the data providers to launch [an] ICE Swap Rate for SOFR once there are sufficiently liquid SOFR swap prices quoted on electronic venues on which to base an ICE swap rate,” says Tim Bowler, president of IBA.

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