Sponsored by CME Group
Despite uncertainty, embrace of SOFR
CME Group's SOFR futures and options contracts have seen “rapid acceleration, exponential growth,” as the market continues to move away from LIBOR, Agha Mirza, CME Group Global Head of Rates and OTC Products, tells Total Derivatives, with the current market environment spurring that growth.
"There’s a lot of uncertainty - inflation is increasing, the CME FedWatch tool is showing a series of rate hikes expected from the Federal Reserve this year, there's uncertainty about the Fed balance sheet composition, and obviously there is heightened geopolitical uncertainty. All of that has led interest rate volatility in past weeks to multi-year highs,” Mirza says.
“When such things happen, when we are in such a highly volatile environment, participants could shy away from getting involved in newer or younger products, which is what SOFR futures and options are,” Mirza notes. However, on the contrary, “during the most volatile weeks for the markets, we saw SOFR futures volumes reach new highs. We've had multiple days of over 2m contracts a day and a high of 2.7m contracts, including record open interest of 4.47m contracts reached in March.
As a result, CME Group’s Mirza believes there is “an underlying strength in the development process of this market.”
Despite conditions that represent a severe stress test for all sides of the market, both Eurodollar and SOFR futures volumes have gone up. “This past month, Eurodollar and SOFR futures volumes together are about 5.5m contracts, of which more than 1.5m are options contracts. It’s been remarkable that both have continued to grow,” Mirza says.
Supporting Eurodollars while encouraging SOFR futures
With regulators putting curbs on USD LIBOR trading at the start of 2022 as the Fed, FDIC and OCC asked banks they supervise not to add new LIBOR exposure, this has created a “strong incentive” to use alternative reference rates. SOFR is “definitely the leading interest rate benchmark, and it is ARRC-endorsed,” notes Mirza.
At the same time, Eurodollars are still the world’s largest short-term interest rate market. Mirza says that “from our perspective, we have always recognized the importance of continuing to support our Eurodollar futures and options, which have many, many global participants and algorithmic market makers. It's important to continue to support this market as long as participants need it."
He continues, “but, we also recognize that in US markets, most of the new activity in OTC derivatives and cash markets has moved to SOFR. We want to remain aligned with OTC markets. We want to make sure that our clients have access to deeply liquid and efficient SOFR futures."
CME Group spent four years developing liquidity in SOFR futures. “We have made sure that clients continue to have a full suite of interest rate products, especially short-term interest rate futures and options. So, we have SOFR futures, SOFR options, and we are clearing SOFR OIS swaps. CME Group also offers the ARRC-endorsed CME SOFR Term Rate that is deemed highly useful for cash market applications. And in response to client demand, CME Group has made futures and swaps available on the credit-sensitive BSBY index," Mirza explains.
Incentives for SOFR futures trading
In order to encourage market-makers, CME Group has made a “significant” investment in working with participants to incentivize market making in SOFR futures, especially further out the curve. “That is something that we enhanced earlier this year,” Mirza says.
“This has now led to the pack and bundles being a very similar percentage of SOFR volumes as for Eurodollars. We’re very happy and excited about this build up in liquidity further out the curve.”
In addition, CME Group has delivered an enhanced value proposition through efficiencies between SOFR and Eurodollar contracts via margin.
“Clients can get margin offsets as high as 90% or above in corresponding three month Eurodollar and SOFR contracts beyond the June 30th, 2023 date” along with Globex listed, inter-commodity spreads that enable "seamless spread trading.”
Moreover, earlier this year CME introduced reduced-tick inter-commodity spreads that peg Eurodollar futures to SOFR futures through the ISDA fallback spread, which is set at 26.161 basis points.
“If clients want, they can switch Eurodollar futures positions into SOFR at exactly the ISDA spread without significant slippage,” Mirza explains.
Stronger client participation; Higher volumes
All these efforts have attracted market participants to SOFR futures. CME Group counts “over 1,000” banks, hedge funds, asset managers and proprietary trading firms who account for 96% of Eurodollar volume. Mirza points out that if you look at the CFTC's Commitment of Traders Report, large open interest holders have also continued to grow in SOFR. “Now they are at a record 418 large open interest holders."
What about volume? CME Group’s Mirza says that “we were trading SOFR futures on average close to 300k a day at end of last year and beginning of this year and that has grown exponentially since. Now, as we speak, we're trading about 1.7m contracts a day.”
In addition, the share of SOFR versus Eurodollar futures has risen sharply. “We’re running at 62% in March,” Mirza estimates. “Our high water mark, a record in SOFR futures as percentage of Eurodollar futures, was 78%.”
SOFR futures options – same suite of products, but long way to go
For options, the situation is a bit different with liquidity and depth in SOFR options behind Eurodollars thus far. Currently, “Eurodollar options go out all the way to four years, and for mid-curves, there are five quarterly expiries and the underlyings are one year, two year, three year, four years out beyond the expiries,” Mirza notes. “Clearly, a lot of Eurodollar options trading takes place on contracts that are further out.”
“Fundamentally, SOFR options are in a very good place because, when you look at the product suite, SOFR options were developed with very significant client feedback which directed us towards replicating the Eurodollar options suite. So, in terms of number of expiries, the types of options and range of strikes, all of that, SOFR has the full breadth of contracts, expiries and strikes.”
Even so, Mirza accepts that from the perspective of some end-users, SOFR options still have “a long way to go” to match Eurodollars.
Mirza stresses that futures have to develop first and develop further out. That’s happened meaningfully over the last couple of months, leaving SOFR options "poised” for further growth. Thus, Mirza believes that “the conditions are right.”
CME Group is “very excited” about the growth in options volumes that the exchange has seen in the last month-and-a-half or so, running up to the March FOMC meeting.
Options volumes and open interest rise from near nothing
Indeed, SOFR options have begun the year growing strongly. “January saw SOFR options open interest of 2,000 contracts. We started February with OI of over 100,000 contracts. We started March with open interest around a million contracts and today SOFR options open interest is 1.35m contracts.” Mirza sees that as “very remarkable” growth.
Moreover, as recently as the beginning of January and fourth quarter of last year, CME Group was doing average daily volume of a couple hundred contracts or lower. “In March and including February we were doing an average daily volume of about 50,000 contracts,” says Mirza.
“In terms of building a vibrant, accessible, flexible market, we have trading in all three venues: Globex, the trading pit for Eurodollar and SOFR options, and blocks. We are seeing a very healthy and strong participant mix comprised of banks, asset managers, hedge funds and proprietary trading firms - similar in composition to Eurodollar options.”
Fungibility of ED options to SOFR
Eurodollar options that have underlying futures that expire in Sep23 and beyond are “essentially options on SOFR risk” because Eurodollar futures for Sep23 expiry and longer are closely linked to SOFR through the ISDA fallback spread, with CME Group planning for conversion of Eurodollar contracts into SOFR in June 2023.
“Prior to the March IMM expiry, there were nearly 40 million contracts in Eurodollar options open interest and at least a quarter of that is linked to SOFR through the fallback. This is a very good starting point for SOFR options,” Mirza contends.
Investment fruition for SOFR
After significant investment in time, effort, and money by CME Group, key SOFR products are seeing strong growth in 2022.
As market participants adapt to SOFR at an accelerating pace, CME Group’s Mirza believes that “education, communication and engagement” along with functionality and further margin efficiencies such as “bringing SOFR products into portfolio margining against swaps" will continue to pay off, opening the path to a virtuous circle of growth, efficiency and liquidity for both futures and options.
Sponsored by CME Group