Futures rise to the occasion as SOFR surges

Cometh the hour, cometh the futures contract. 

Last month’s spasm in US money markets, which saw the secured overnight financing rate (SOFR) vault to an unprecedented 5.25% on September 17, prompted criticism of the newborn benchmark – but also gave CME Group’s fledgling derivatives products based on the rate a chance to shine.

Launched in May 2018, SOFR futures allow traders to hedge their overnight repo exposure using contracts with one-month and three-month maturities. Yet despite SOFR’s position as heir apparent to Libor as king of interest rate benchmarks, the market for the futures proved sluggish at first.

It took 10 months for open interest in the contracts to breach 100,000 contracts, and the mean of average daily volumes for those months was just 10,625. In contrast, CME’s Libor-linked Eurodollar contracts had open interest and volumes in the millions.

The thin volume of SOFR futures trading meant high price volatility – a characteristic loathed by market participants. It also frustrated efforts to build a SOFR yield curve using trade data, for the simple reason that there just wasn’t enough of it.

SOFR hedging may well become a hallmark of the post-Libor markets

But last month saw the contracts ushered into the spotlight. On September 17, SOFR futures became a trillion-dollar market, with open interest in the contracts climbing to 312,000 lots and daily volume topping 152,000. 

Thomas Wipf, chief of the Alternative Reference Rates Committee, the body charged with promoting SOFR, said market participants turned to derivatives to hedge the volatility that day’s repo activity injected into the rate – fulfilling the purpose for which they’d be introduced in the first place.

And though trading slowed down following the spike, average daily volume for September stood at 58,449, compared with 39,925 for August, while month-end open interest hit 429,066, up from 282,321.

SOFR hedging may well become a hallmark of the post-Libor markets. The Federal Reserve has pledged to stay in the repo market through to November 4 to nix the possibility of another surge in the overnight rate. But if and when it steps out, the systemic factors that most likely led to the September spike – a paucity of excess reserves and restrictive liquidity requirements among them – will remain, meaning future turbulence cannot be ruled out, especially around the typically unruly year-end.

It may have taken a market panic, but it looks as if SOFR futures have finally hit their stride.