Derivatives clearinghouses have adopted the secured overnight financing rate, or SOFR, to value US dollar interest-rate contracts representing roughly three-quarters of that market, marking a significant development in the broader market's transition away from Libor.
Regulators identified changes at clearinghouses as an important step towards replacing various interbank offered rates that underpin countless financial transactions following concerns over the soundness of these benchmarks.
The sheer volume of swaps that pass through central counterparties, which act as middleman in trades to reduce the risk of defaults cascading through the financial system, mean they play a pivotal role in setting standards for the wider market.
LCH, the London-based CCP that handles over 90% of cleared interest-rate swaps globally, said it had moved over one million contracts totalling US$120trn to SOFR.
The move was away from Fed Funds rather than Libor, as cleared swaps haven't referenced Libor for some time, instead using overnight interest rates such as Fed Funds. But the fact that clearinghouses represent comfortably the largest pool of swaps market liquidity means they can be instrumental in shifting market norms.
The hope is that the move to SOFR will prompt a wider uptake among market participants that don't usually clear trades, such as corporate treasurers, which still tend to reference Libor in their swaps transactions.
"It's a very significant milestone in the move away from Libor both for us and for the dollar swaps market more broadly," said Susi de Verdelon, head of SwapClear and listed rates at LCH.
"If you can change the conventions in [the] cleared swaps market, you can change a significant portion of the OTC rates derivatives market very quickly. It's an important step-change, made practicable because you have a central entity coordinating the work and pushing the transition forward."
CME Clearing has also transitioned over US$7.2trn in US dollar cleared swaps, according to Sunil Cutinho, senior managing director and president at the firm.
CLEARING THE WAY
Libor became a crucial benchmark in the financial system over the past several decades, acting as the reference interest rate in about US$300trn of financial transactions across the globe, including derivatives, bonds and loan markets.
Around two-thirds of those trades are in US dollar markets, according to the Federal Reserve’s Alternative Reference Rates Committee.
Regulators and market participants have long viewed moving derivatives markets – and cleared derivatives in particular – as an important step in the transition away from Libor. About three-quarters of the US$449trn interest-rate swap market is cleared, according to the Bank for International Settlements.
"A discounting regime change at a CCP focuses its members and clients on managing risk to that new benchmark and helps build swap market liquidity. Market activity and attention on the new index should continue to increase from here,” said de Verdelon.
Until now, derivatives transactions linked to alternative reference rates have been less common outside of clearing. Unilever entered a US$500m SOFR-linked interest-rate swap in September with JP Morgan to hedge a 10-year bond issue – the first long-dated corporate SOFR swap.
Bankers and other market participants are hopeful such deals will now become more commonplace.
“We expect this to be the catalyst for a step-change in trading volumes in SOFR derivatives, bringing a transition in the broader market much closer,” said Tom Wipf, chairman of ARRC and vice chairman of international securities at Morgan Stanley.