Sponsored by CME Group
CME Term SOFR Rates have arrived
In a recent conversation with Total Derivatives, Agha Mirza, CME Group Global Head of Rates and OTC Products, discussed the exchange's new term SOFR rates (link), the continued growth of SOFR products and the progress of transition to the alternative reference rate.
Volumes trend higher in SOFR futures
Looking back, Mirza highlights that CME has been involved with LIBOR transition work, supporting the regulatory and industry efforts, "as members of ARRC since 2015,” with the objective being "to serve our clients as best as possible, and do things that are in the industry’s long-term interests.”
Moreover, CME felt it was important to support regulators’ efforts to bring in benchmarks that are "based on transactions from robust markets and are IOSCO compliant.” Mirza points out that CME Group has had “over 3,200 client engagements globally on SOFR, alternative reference rates and similar topics,” it estimates.
CME Group’s views have been “very much shaped by clients,” Mirza stresses, and in this regard, the exchange launched SOFR futures "very soon" after the SOFR index was created in 2018. And CME's SOFR futures have grown in a "very strong and encouraging manner.” For example, Q1 2021 trading volume in CME SOFR futures rose to 112K contracts ($232bn in representative notional) per day in Q1 2021, representing a 61% increase QoQ and a 98% increase YoY (link).
Born out of client demand and engagement
Along with the growth in SOFR futures, since the index was created, a number of market participants have told CME that, "there are certain cash market applications and client types for whom an interest rate benchmark index with a forward-looking – also called term - component will be important,” Mirza recalls.
Thus, CME Group is responding to "strong client demand” in creating term SOFR rates. Working over a three-year period with market participants, CME Group has designed a methodology that works with implied rates in both futures and OIS swaps as inputs, and calculates 1m, 3m, and 6m term SOFR benchmarks (link).
Mirza adds, “we are able to calculate robust estimates for 1m, 3m and 6m rates by sourcing as many transactions and executable quotes as possible, bringing these transactions together in a logical and usable manner and applying rigorous analytics for the projection of forward rates.”
SOFR futures network key
In parallel with this work, a key focus for CME Group has been the strong development of the SOFR futures ecosystem, Mirza highlights.
“We have now grown to over 550 global institutions participating, comprised of asset managers, hedge funds, banks and proprietary trading firms.” Growth trends are "very strong” in “a large, robust market composed of diversified participants,” he notes.
Despite being in a low volatility environment “where you typically don’t get that much hedging and risk management taking place in the short end”, on a relative basis, Mirza highlights that there are “around $75bn in daily notional-based transactions underpinning the 1m calculation, $125bn in daily notional transactions underpinning the 3m calculation, and over $160bn of transactions that are used for the 6m calculation.”
Aligning to the ARRC principles for term SOFR
With the ARRC announcing principles for term SOFR recently, Mirza believes CME Group is “clearly aligned with each of the key three principles.”
He explains that, “we agree with a term rate should have a limited scope of use so that the use does not materially impact volumes in the underlying SOFR-linked derivatives transactions that are relied upon to construct that rate.”
And, combined with the strong need for a forward-looking term SOFR rate, the fact that the licenses for CME Term SOFR will be limited to use for cases that are in the cash and loan markets, "essentially ensures alignment with the third principle that the ARRC has communicated,” Mirza says.
He also points out that transactions are “large and sufficient enough to make the rate IOSCO- and BMR-compliant, which is already very much the case.”
As for hedging needs, Mirza notes that “as CME Term SOFR is derived from SOFR derivatives, so there is a very close correlation and we believe for most cases, any necessary derivatives hedging can use the OIS swaps and OIS derivatives which are based on the overnight SOFR index.”
Meanwhile, liquidity in Eurodollar futures and options remains “very strong, diversified, deep and extensive.” With the fallback methodology made effective March 29th, the futures markets of SOFR and Eurodollars are “very closely linked,” Mirza says.
“As for March 5th, the ISDA spread – which is basically the credit spread or the link between the SOFR and LIBOR indexes – was fixed at 26.161bps and as of Jun 2023, we would convert Eurodollar futures with the ISDA spread 26.161bps to SOFR futures” and in that sense the two are closely linked,” he explains.
Addressing comparisons with other risk-free rates such as GBP SONIA, Mirza highlights that, compared to the two-decade-old UK rate, “SOFR is a three-year old index,” and as a product that was launched only a few years ago, the current rate of progress “is strong and encouraging.”
Finally, Mirza notes that CME Group continues to participate in the ARRC term RFP and in that regard, it has made "significant and detailed submissions into ARRC in relation to term RFP and we are hopeful there will be a recommendation in the not-so-distant future.”
Sponsored by CME Group