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Counting down to dollar Libor transition

Counting down to dollar Libor transition

While the sterling, Swiss franc and Japanese yen Libor transitions went smoothly, derivatives traders face an event multiple times bigger with the US dollar transition, which affects many more participants. In a Risk.net webinar sponsored by Numerix, experts discussed the impact of market volatility on transition, the availability of term secured overnight financing rate (SOFR), developments in non-linear markets and management of forthcoming central counterparty (CCP) conversions. Here we explore five themes that emerged from their discussion

The panel

  • Liang Wu, Senior vice-president for financial engineering and product management, and head of rates, Numerix
  • Katie Craig, US rates strategist, Bank of America Global Research
  • Guarav Shukla, Partner, PwC advisory practice
  • Moderator: Helen Bartholomew, London bureau chief, Risk.net

The impact of volatility

While recent volatility in the banking sector and rates market has alarmed many market participants, it is not expected to have a significant impact on their readiness for the transition away from Libor, according to the panellists. Participants have been preparing for transition for a long time.

However, Gaurav Shukla, partner at PwC’s advisory practice, believes continued disruption could be problematic. “More volatility in the rates market … could have an impact on the post-cessation environment, particularly in CME term SOFR, which may require hedging strategies,” he said. Currently, the overnight SOFR rate has been stable and predictable compared with Libor, which has been more volatile.

Term SOFR has been more volatile than overnight SOFR, but still reflects the expectations of the US Federal Reserve. It does not capture the credit risk component, which is highlighted during times of stress. Katie Craig, US rates strategist for Bank of America Global Research, noted that SOFR can, however, occasionally exhibit idiosyncrasies in cash collateral dynamics that may be unfamiliar and puzzling to market participants: “Term SOFR smooths out the volatility of overnight SOFR so that even a large jump or drop in SOFR may only result in a slightly higher or lower term SOFR rate.”

CCP conversions and fallbacks

Liang Wu, Numerix
Liang Wu, Numerix

Most of the CCP conversions will happen before July 1, 2023, which is seen as a positive development. The complexity and scope of the transition pose challenges for financial institutions, with different schedules and methodologies across CCPs and product types. While CCPs have answered questions from financial institutions, the panel noted there were lingering questions around the cut-off dates and execution diligence.

CCPs are trying to improve the conversion process for their users by way of consultations, with LCH and CME taking slightly different approaches. Liang Wu, senior vice-president for financial engineering and product management, and head of rates at Numerix, said: “It is important to know the specific instruments being converted and whether there will be any value transfer, which will be compensated in cash.” End-users are expected to be well prepared for the upcoming conversions and fallback approaches, which are considered straightforward.

The International Swaps and Derivatives Association's (Isda's) Ibor fallbacks protocol serves as the foundation for both uncleared and cleared swap fallbacks, with CCPs taking slightly modified versions. The details of the fallbacks are similar to those of traditional risk-free rate swaps, but there are differences in payment and day shifts, as well as observation period shifting.

Market participants are currently using historical spreads that form part of the Isda fallback for credit-sensitive adjustments. However, the recent volatility highlights the value of credit-sensitive instruments, and the panellists noted that some clients may ultimately prefer to use credit-sensitive rates, such as Ameribor or the Bloomberg Short-Term Bank Yield Index (BSBY) in the future.

Lending markets

While the derivatives market has largely transitioned to SOFR contracts, lending markets, which still have contracts tied to Libor, may see greater disruption post-transition. They have been slower in transitioning to SOFR, with market participants reluctant to fully accept the benchmark and eager for credit-sensitive rates.

“There is a mismatch risk when hedging a term SOFR loan with a SOFR swap, which has led some lenders to choose credit-sensitive alternatives such as BSBY,” Craig explained. Credit-sensitive rates have also seen some drawbacks and liquidity remains an issue. However, if borrowing costs increase but floating lending rates remain static or fall, there may be increased demand for credit-sensitive alternatives.

The panellists stressed that participants should review lending contracts that have not been properly remediated, as they may fall into different categories. Being prepared before June 30 is crucial for a smooth transition.

Changes to the use of term SOFR

Speaking prior to the Alternative Reference Rates Committee’s (ARRC’s) recent announcement on the loosening of restrictions on term SOFR usage, panellists noted the challenges they had been facing. Limiting term SOFR to direct hedging of cash instruments for end-users, with dealer-to-dealer hedging restricted across financial institutions, had led to a one-sided market in term SOFR, resulting in a basis between overnight SOFR and synthetic term SOFR. The basis typically ranged from one to two basis points, but could be more volatile depending on market conditions. As a result, concerns had arisen about liquidity and the ability to hedge term SOFR risk.

Market participants had been pushing for the development of term SOFR derivatives to allow for better hedging of term SOFR risk.

Incorporating swaps into the methodology for printing CME term SOFR may increase the volume under CME term SOFR, and potentially reduce volatility in term SOFR prints. However, Shukla noted such a move may require “careful consideration of the differences in the forward curve constructed using swap data versus observable transactions in term SOFR".

Regarding legacy hedging derivatives under the Isda protocol, the panellists explained it may be possible to switch from Libor to term SOFR instead of compounded SOFR, but it would depend on the dealer and may vary across the market. Novation may allow for term SOFR hedging between two banks, but this would probably be a specific situation and not broad-based dealer-to-dealer hedging.

The lack of an interdealer market for term SOFR had made it difficult to determine market pricing, leading to challenges in comparing curves with the market.

Building term SOFR curves

The panellists discussed the challenges of building term SOFR curves. According to Numerix’s Wu, one approach is to use the CME methodology used for SOFR futures, particularly the one-month and three-month futures, which have good liquidity up to five years of maturity. Another consideration is the liquidity of the overnight SOFR market, which may be used to extend the curve horizon beyond futures to futures plus swaps.

Basis modelling between term SOFR and overnight SOFR can also be used to construct the curve, Wu said. In a cap-and-floor market, term SOFR derivatives have similar or even larger volume compared with overnight SOFR, indicating their significance in hedging term SOFR loans. “As the market grows, different proposals for constructing corresponding volatility surfaces may emerge to meet the needs of term SOFR issuers and backward-looking SOFR instruments,” he added.

According to the panellists, the CME methodology used for futures could be a risk factor contributing to the basis seen between the term SOFR and overnight SOFR rates. While the difference is based on market supply and demand, constructing a curve solely based on overnight SOFR instruments may result in a different term SOFR rate compared with other methods.

Constructing a forward curve for term SOFR is challenging because of limited transactions in term SOFR and the need for transparent transactions to construct a true forward curve.


Some of the concerns expressed by panel members about liquidity and basis risk may now have been allayed by the ARRC’s loosening of restrictions on term SOFR, but continued monitoring and consultation will be required as term SOFR use cases grow and the market evolves. There is often a trade-off between what the market wants and what regulators give.

Panellists also noted the market’s continued appetite for credit-sensitive rates. Any tightening credit cycle in future may lead to broader adoption of credit-sensitive rates, particularly in the lending markets.

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