Libor’s Heir Presumptive Boosted by Proposed Swaps Trading Shift

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The officially favored benchmark to replace Libor in dollar funding transactions is getting a shot of adrenaline as deadlines draw closer and the push to adopt one or more of the various alternatives becomes more urgent.

The Secured Overnight Financing Rate -- the option that’s preferred by the Federal Reserve-linked Alternative Reference Rates Committee -- has long been the frontrunner to succeed the beleaguered London interbank offered rate in U.S. markets. But it also has deficiencies in the eyes of some observers, such as the lack of a credit-sensitive component and the absence of a term structure. Now, however, new developments mean the latter problem at least might be one step closer to being remedied.

A subcommittee that advises the Commodity Futures Trading Commission has recommended that interdealer brokers replace trading of linear swaps tied to Libor with trading of SOFR linear swaps from July 26, with the ARRC also endorsing this approach. If that comes to pass, it could accelerate the creation of officially sanctioned term SOFR rates, which have been held back in part by a lack of market depth in related derivatives.

Chicken and Egg

Trading in SOFR derivatives has long been ensnared by a Catch-22: People haven’t wanted to trade it because of the lack of liquidity, yet it won’t be robust unless there’s trading. And without liquidity, the ARRC has been hesitant to recommend a term SOFR rate.

“The main issue is liquidity,” Thomas Pluta, global head of linear rates trading at JPMorgan Chase & Co., said during a panel discussion hosted by the ARRC on Tuesday. “We’re in a chicken-and-egg situation and it highlights why we need a big-bang push to the market.”

The continued growth in derivatives volumes linked to SOFR is a key market indicator that the ARRC has said it will consider in recommending a forward-looking curve tied to the benchmark. Last month it selected CME Group Inc. as the administrator for the hotly anticipated term rate.

British Precedent

There are reasons for U.S. officials to be optimistic about the kind of interdealer transition proposed by the interest-rate benchmark reform subcommittee of the CFTC’s Market Risk Advisory Committee. A similar transition in the U.K. was introduced in October 2020 and back then the Sonia benchmark accounted for just 30% of swaps volume, according to the U.K. Financial Conduct Authority’s Edwin Schooling Latter. That figure jumped rapidly to around 50% and it now stands close to 70%.

“One of the main drivers of this directive is to reduce interdealer hedging costs into SOFR and increase liquidity and visibility,” said Bart Sokol, a managing director for U.S. interest-rate swap trading at Barclays Plc. “There’s a large cohort of clients looking for efficient hedging mechanisms and this will help bring SOFR to the forefront of that.”

Thomas Wipf, chairman of the ARRC and also head of the CFTC-linked subcommittee on benchmark reforms, said the July 26 transition date could accelerate the creation of term SOFR.

Endorsement

“It really starts moving us into a position by endorsing term SOFR in days, not weeks, after that because of the size of the market,” he said during the ARRC event Tuesday. “We have the ability to actually deliver on term SOFR while moving the derivatives market forward.”

The so-called SOFR First initiative “could play an important role” in boosting the market for derivatives linked to SOFR, “but issuance of cash products linked to the benchmark will be even more critical as this will create an economic need to hedge,” TD Securities strategists, led by Priya Misra, wrote in a note to clients following the CFTC announcement.

Still term rates are just one aspect of the transition, and many other factors affect decisions by market participants to use SOFR or other competing benchmarks such as ICE Benchmark Administration’s Bank Yield Index, Ameribor and the Bloomberg Short Term Bank Yield Index. The latter is administered by Bloomberg Index Services Limited, a subsidiary of Bloomberg LP, the parent of Bloomberg News.

ABS Deal

Meanwhile, SOFR received an additional boost Tuesday to coincide with the ARRC’s symposium on the topic, with one of the world’s best-known car manufacturers announcing that it has begun drawing on securitization facilities linked to the benchmark.

Ford Motor Credit Co. established its first-SOFR-tied asset-backed securities facility with JPMorgan last month to replace a Libor-based one, and it has since added a second facility, according to an emailed statement from the company.

The ABS deal “represents one of the first of its kind on the back of an ABS financing, and is an important milestone as the market seeks to transition away from Libor,” said Gregg Geffen, head of North America corporate interest rate derivative marketing at JPMorgan.

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