The adoption of alternative risk-free rates in derivatives trading has increased according to a new indicator, with the use of US dollar risk traded in the secured overnight financing rate (SOFR) at a record.
The ISDA-Clarus RFR Adoption Indicator was at 6.8% last month according to Clarus Financial Technology, the derivatives analytics provider.
Chris Barnes at Clarus said in a blog: “The RFR Adoption Indicator moved higher from 4.7% the prior month, reaching the highest level since February.”
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After the financial crisis there were a series of scandals regarding banks manipulating their submissions for setting benchmarks across asset classes, which led to a lack of confidence and threatened participation in the related markets. As a result, regulators have increased their supervision of benchmarks and want to move to risk-free reference rates based on transactions, so they are harder to manipulate and more representative of the market.
The Financial Conduct Authority, the UK regulator, has said it will not compel banks to make Libor submissions after 2021.
Last month the International Swaps and Derivatives Association launched an indicator to monitor the adoption of alternative risk-free rates in derivatives trading which was developed with Clarus.
Scott O’Malia, chief executive of ISDA, said in a statement: “These indicators will provide important clarity on what’s been achieved and the work that remains to be done ahead of the end of 2021.”
The indicator provides a monthly snapshot of RFR trading activity in interest rate derivatives markets, based on global cleared over the counter and exchange-traded derivatives data from seven central counterparties spanning six currencies. The indicator tracks activity using DV01, a measure of risk representing the change in value of a derivative contract resulting from a parallel one basis point shift in the swaps curve.
“Of particular note, 3.8% of all US dollar risk was traded in SOFR,” added Barnes. “This was higher than the previous month (3.0%) and sets yet another record for SOFR risk.”
The UK has chosen the sterling overnight index average, Sonia, as its risk-free rate while the US has adopted SOFR to replace US dollar Libor.
Switching discount rates
As regulators have encouraged derivatives into central clearing, CCPs are changing the way they value positions to use RFRs, in order to move the industry away from Libor.
Barnes continued that the discounting switch to €STR at central counterparty clearing houses occurred in July and so had a small impact on the amount of €STR risk traded.
The European Central Bank began publishing its new benchmark, €STR, the euro short-term rate, for the first time in October last year. The previous benchmark, EONIA, has been redefined as €STR plus a fixed spread of 8.5 basis points.
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Matthias Graulich, member of the executive board at Germany’s Eurex Clearing, said in a post that the switch was very smooth over the weekend of July 25/26.
Graulich wrote: “It may sound banal at first glance. But it is a Herculean task if you consider that Eurex Clearing manages outstanding positions in OTC euro denominated interest rate derivatives with a notional value of €18.6 trillion. Gains or losses arising from the changed discounting had to be offset for each individual position so that, in the end, no market participant is better or worse off than before.”
He continued that the switch should give market participants a further push to build positions in their overnight index swaps based on €STR.
CCPs are also due to convert discounting for US dollar-denominated swaps to SOFR from the daily Effective Federal Funds Rate (EFFR) on October 16 this year.
Fallback protocols
Last week the Alternative Reference Rates Committee wrote to its members to be prepared to sign onto ISDA's Ibor Fallback Protocol and Ibor Fallback Supplement that will implement new fallbacks for legacy and new derivative contracts, respectively.
ARRC is a group of private market participants convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition to SOFR.
Tom Wipf, chair of ARRC and vice chairman of institutional securities at Morgan Stanley, said in the letter that the protocol will be significant in preserving derivatives market functioning and allowing Libor derivatives contracts to continue to perform through the transition.
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"By adhering to the protocol, your firm will be protecting itself from the risk of disruption should Libor become unavailable," Wipf added. "That’s because adherents to the protocol will agree that existing derivative transactions that they have entered into with other adherents will incorporate ISDA’s new fallback language."
He continued that widespread adherence to the protocol is a vital step in the transition to more robust reference rates, and is essential to addressing both individual firm risks and systemic risks associated with the discontinuation of Libor.
"I know it takes time and close coordination within your institutions to adhere to the protocol — so do not wait for the protocol’s official launch to prepare," said Wipf. "I encourage everyone to start the conversation about this at your institutions immediately, so that they will be in a position to adhere to the protocol as soon as possible."
