Rare SOFR Trade Highlights a Key Glitch in Libor’s Transition

(Bloomberg) -- A unique trade in options tied to the Secured Overnight Financing Rate turned heads in the U.S. rates options market on Tuesday, showing how far the contracts are from linking to Libor’s replacement. 

The short call position was in the December three-month SOFR options, referenced by futures tied to Libor’s heir, which is the current benchmark for the popular eurodollar options. The trade size was just 5,000 contracts. But it still was more than double the outstanding positions held across all three-month SOFR options, a miserly 7,772 contracts as of Tuesday’s close. 

It’s a clear sign that while SOFR futures activity may be rising, the options still have a long way to go before attaching to the newly adopted overnight rate. In terms of futures activity, average daily SOFR volumes are now around 17% of eurodollar futures, up from around 5% at the start of October. Still, the depth of the SOFR futures market still appears to be too shallow to warrant support from traders exploring SOFR-based options, given a lack of efficient delta-hedging requirements. 

The timing of the transition could be problematic. Expectations for the Federal Reserve’s first rate hike are creeping closer, as some strategists predict it will come as soon as March. So trader’s will still have to rely on eurodollar options to hedge positions around the perceived path of central bank hikes, rather than switching to Libor’s somewhat lagging heir. 

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