CME unveils term SOFR in face of ARRC doubts

Exchange group says benchmark aligns with ARRC principles – but committee has pushed back endorsement plans

Term-SOFR-settings montage

CME has forged ahead with its term version of SOFR – the official replacement for US dollar Libor – just a month after a regulator-backed working group said it would not be able to endorse such a rate before year-end.

The Alternative Reference Rates Committee, which is tasked with weaning US markets off Libor, last month pushed back its planned June 2021 endorsement of a term SOFR benchmark. It argued the rate would not be robust as there was not enough volume in the derivatives that would underpin it.

CME, which is also a member of the ARRC, disagrees with that view, and has now made one-, three- and six-month settings available for use in loans and other cash instruments, stealing a march on rivals that are working on their own term benchmarks. SOFR futures listed on the exchange traded $232 billion in average daily notional during the first quarter. Around $125 billion in daily notional underpins the three-month setting.

SOFR futures have organically grown to a very robust level, and given the low level of rates and volatility, it’s not unreasonable to say that these volumes represent a good base case,” says Agha Mirza, global head of rates and over-the-counter products at CME. “From here, one could expect the volumes to grow as SOFR comes full swing, now that we’ve had very material regulatory announcements.”

Initially licensed free of charge, CME’s rate will only be available for use in cash instruments. Regulators have been insistent that a term benchmark should only be used in limited cases – primarily where loan products will struggle to adopt the overnight rates chosen as Libor’s successors.

ARRC chair Tom Wipf has welcomed CME’s decision to limit use of the benchmark, but reiterated concerns around current liquidity conditions.

“The fact that CME won’t license its term rate for derivatives before June 2023 is helpful and aligns with the ARRC’s principles, however, the ARRC is not yet ready to recommend a forward-looking SOFR term rate. The ARRC is swiftly working to identify the conditions we believe are necessary to recommend a term rate, and we would recommend a rate when those conditions are met – which could be as soon as this year if market participants move to SOFR more,” said Wipf in an emailed statement.

Libor’s endgame

On March 5, the UK Financial Conduct Authority, Libor’s regulator, and its administrator, Ice Benchmark Administration, confirmed a June 2023 end-date for US dollar Libor. Four other currencies, including sterling and Swiss franc, will see their Libor benchmarks cease at the end of 2021. US regulators led by the Federal Reserve have ordered market participants to stop issuing new contracts referencing Libor after the end of this year.

Each of these currencies has its own replacement benchmark, but those replacements are overnight rates and would need to be compounded in arrears to calculate a term interest rate. This is unpalatable for some lending markets, in particular trade finance, where forward visibility on interest payments is required.

Markets have been proceeding on the assumption that a term version of the Libor replacements would at some point ride to the rescue. In the US, term SOFR is already widely embedded in regulator-approved cash fallbacks – legal documents that re-hitch a Libor-referencing instrument to a replacement rate when Libor dies. Cash bonds, syndicated loans and securitisations all have term SOFR atop a waterfall of replacement rates. Without an ARRC recommendation, most contracts would default to standard SOFR, compounding in arrears.

Availability of CME’s term SOFR – albeit without regulator endorsement – comes as market participants explore a growing array of alternatives to Libor’s official replacement rate. Regional US lenders including Frost Bank and Signature Bank have already linked cash contracts to Ameribor, a measure of overnight lending among 200 regional banks conducted over the American Financial Exchange. A new 30-day term version, which combines AFX trades with wider bank funding data, will be adopted by Zions Bank for commercial lending later this year.

In my evaluation, CME term SOFR meets the three principles announced by the ARRC. We believe we are fully aligned on all criteria
Agha Mirza, CME

On April 21, Bank of America issued a $1 billion six-month floating rate note referencing Bloomberg’s short-term bank yield index, or BSBY – a credit-sensitive benchmark that went live in March. The index has been devised with SOFR in mind and can be layered over a term version to mimic the forward-looking and credit-sensitive nature of Libor.

CME claims its term SOFR rate conforms with all 19 benchmark principles set out by global standard-setter the International Organization of Securities Commissions. Published out of CME Group Benchmark Administration, a regulated entity, the rate is also compliant with the European and UK Benchmarks Regulation – which takes its lead from the Iosco principles – meaning it is available for use by international participants.

Crucially, Mirza says the rate satisfies three key principles published by the ARRC for recommending a term SOFR rate. Published just a day before CME made its rate live, these principles require a benchmark to meet ARRC’s criteria for alternative reference rates, be rooted in a “robust and sustainable base of derivatives transactions over time” and have limited scope for use.

“In my evaluation, CME term SOFR meets the three principles announced by the ARRC,” says Mirza. “We believe we are fully aligned on all criteria and are happy to assist clients and market participants who have shown strong demand for term SOFR for certain use cases.”

Liquidity doubts

The ARRC is yet to be convinced on the base of SOFR transactions. In a March 2021 progress report, the group raised concerns that short-dated SOFR derivatives trading had flattened over the past year. It noted the first four monthly SOFR contracts listed at CME saw fewer than 10 trades on roughly 20% of trading days during the fourth quarter of 2020.

“Growth in long-dated maturities is vital to the transition, but lack of progress in short-dated trading, which is what any potential term rate would need to be based on, has made it difficult for the ARRC to recommend a term rate,” says the ARRC in the report.

CME’s Mirza says overall futures growth, in excess of 80%, has come at a time of near-zero rates and low volatility. He adds that SOFR futures volume outpaced Fed funds contracts during the first quarter. “Everyone knows that Fed funds futures are a robust, very well-established, 30-year-old market with numerous global participants, and it serves critical risk management and hedging needs with volumes in the several hundreds of thousands of contracts,” says Mirza.

During the quarter, CME Eurodollar futures, which reference three-month Libor, traded $2.6 trillion of daily notional. CME will automatically convert remaining Eurodollar contracts to SOFR ahead of the benchmark’s June 2023 demise.

“We regard volume in multiple ways and holistically. It’s also good for people to pay attention to the path forward from a fallback perspective,” Mirza says, alluding to the pool of Eurodollar contracts that will be siphoned into the SOFR market.

A request-for-proposal issued by the ARRC in September 2020 attracted at least three firms aspiring to become the recommended provider.

Rival candidates include Ice Benchmark Administration and Refinitiv, which have proposed overnight index swap (OIS) methodologies for term SOFR construction. This aligns with forward-looking UK term benchmarks the providers have already launched on sterling overnight index average, or Sonia. IBA currently publishes a futures-based term SOFR in beta form, though these instruments may be relegated to a second layer of the waterfall in the event of ample OIS data.

An OIS-based rate – which avoids the modelling assumptions required to stretch fixed-expiry futures contracts into one-, three- and six-month settings – is currently out of reach in the US market. In March, SOFR represented less than 5% of traded US interest rate swap risk by DV01.

Exchange-style trading of the instruments over central limit order books is also crucial to generate inputs for an OIS-based benchmark similar to those available in the UK. Interdealer broker Tradition made SOFR swaps trading available on its Trad-X platform in March, but continuous, two-way dealer quotes are yet to materialise.

CME’s Mirza says the exchange group will add new inputs to bolster its rate, including OIS quotes and swaps transaction data, once liquidity builds.

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