Risk-based futures

Financial Fiction Episode 3: Risk-based futures

For linear interest rate derivatives, risk and DV01 are considered as very similar expressions.

This is also what we can deduce from the name of the latest new futures launch by NASDAQ.

Some five years ago, I proposed a new design for interest rate futures that I called risk-based futures. I worked with ASX in 2014 to adapt the design for the AUD market. At the end of 2015, ASX launched a swap futures based on that design. The ASX product has an extra feature of having a variable tick value, but the central feature of the design is the same: a futures price representing a rate or yield and the physical delivery of an ATM trade on the futures expiry.

NASDAQ will be launching soon its DV01 Treasury Futures. According to NASDAQ, the new product will be available for trading on Thursday, July 19, 2018, pending regulatory approval.

The name "risk-based futures"(1) has been changed to "DV01 futures", but the central idea is the same: future style margin on the price multiplied by a conventional DV01/PVBP and physical settlement at expiry into an at-the-money trade.

In my generic design the delivery mechanism can take several variants. NASDAQ has selected the simplest one where the notional of the delivered trade is fixed in advance. This create a jump in risk at delivery. The risk jumps from the futures term-sheet DV01 (e.g. 850 USD by basis point for the U.S.10-yr DV01 Treasury futures) to the actual DV01 of the delivered instrument. The variant is to deliver at expiry a trade with a notional adapted to smooth the risk.

The design of the futures I proposed is very versatile. As mentioned above, ASX has proposed a version; the underlying is a BBSW swap. The NASDAQ is now proposing a version with US Treasury underlying. I have proposed a version for the overnight-indexed market. The overnight-linked market is expected to become more important with the increased importance of SOFR, SONIA and probably a new EUR overnight benchmark. I will publish the details of the OIS based version in the coming weeks.

Another financial fiction becoming reality! See Financial Fiction 1 and Financial Fiction 2.

(1) I used that name at the The 3rd Interest Rate Conference (London, UK) in March 2015 in a presentation with the title Deliverable Swap Futures: a risk-based design.


Triple basis

In a recent Risk article (Clearers diverge on SOFR swaps discounting - subscription required) it was indicated that, contrarily to previous announcements, when CME will start to clear SOFR linked swaps, the interest used for Price Alignment Interest (PAI) will be SOFR itself and not the EFFR which is used for other USD OTC derivatives. This is also a departure from the initial ARRC suggestion. Regarding LCH, the current indication is that it will clear SOFR linked swaps with EFFR PAI.

This means that out of the six variations of overnight-linked derivatives discussed in a previous blog, five will be available in Q3. It is not certain that the sith variations will ever be really traded, but we can expect that if SOFR is becoming the benchmark benchmark (I'm not sure it is the correct term, but it seems appropriate here) at some stage some legacy EFFR OIS will switch to SOFR for collateral.

From a long term perspective, it seems logical to clear SOFR based swaps using SOFR collateral interest. Starting with EFFR collateral would mean that at some stage in the future, the CCP rule or the master agreement would need to be changed to switch to the new rate.

Now a trick questions: When will the basis swaps EFFR v SOFR start to trade/clear? What will be the PAI on those swaps?

Over the recent years we have seen the appearance of a basis between swaps traded at different CCPs. With this announcement we will see the appearance of a triple basis: on top of the CCP basis, we will have the discounting basis (SOFR v EFFR) and the "convexity adjustment" basis (on SOFR forwards). It will be impossible to untangle those basis as there will be for the moment only a limited number of traded swap types out of the multiple combinations and no option market yet.


EIB SONIA-linked bond

The move to the use of overnight benchmarks as the main interest rate benchmarks is progressing. After the wave of new overnight-linked futures in the last months by CME, ICE and CurveGlobal, we now have a large overnight-linked bond issuance. The EIB has successfully issued a one billion 5-year SONIA-linked bond.

The coupon payment is based on the backward-looking overnight SONIA composition plus a spread of 35 basis points (Maturity 2023-06-29, quarterly payments, ISIN XS1848770407). Note that a small 2 millions bond had been issued in January (quarterly SONIA + 25 bps, maturity 2023-03-20, ISIN XS1889459713). Thanks to an acute observer of the market for pointing that to me.

Backward-looking overnight is viable. Certainly for some issuers and investors. There was never a doubt about it for some market participants. This does not prove it is viable for all market participants, and this is where the question lies. Note that the coupon will be paid with a five-day lag after the last overnight benchmark fixing. This is a serious discrepancy with the current overnight-linked derivative market which pays with a zero day lag in Sterling (and 2 in EUR and USD). Some elements of the issuance are discussed in a Risk article 'EIB shrugs off term RFR worries with Sonia bond plan' (subscription required) and a Financial Times article 'EIB to offer Libor alternative with Sonia-based bond' (subscription required).

The question of backward-looking or forward-looking — i.e. OIS benchmark — overnight-linked coupons is heavily discussed in the potential LIBOR discontinuation and fallback provisions. The EIB issuance, even if linked to backward-looking overnight benchmark, does not bring any substantial positive information regarding the fallback discussion. If anything, the five-day lag expresses the difficulty of that approach. The backward looking payments have been used for many years in the derivatives market and there is not doubt that they are working for products designed with its requirements in mind.

Regarding the LIBOR fallback, the products linked to LIBOR have been designed with the term rate at their core. Can we replace a term rate by a backward-looking rate? That is the question. The answer is: in some case yes and in some cases no. The obvious 'no' are FRA with FRA discounting settlement and LIBOR in-arrear that require a payment at the start of the term period. As the fallback procedure should be the same for all LIBOR usages in derivatives, the global answer to the fallback procedure question has to be 'no, a backward-looking fallback is not possible'. The above answer is not only a personal opinion, it is a physical impossibility, except if one can realize backward time travel.

I will provide more technical details and opinions about the LIBOR fallback in a forthcoming notes. Hopefully I will have time to finish it by mid-July.


Multi-curve framework: double or quits?

This blog entry is a reaction to the column by Bakkar and Brigo in Risk titled Model risk in the transition to risk-free rates. While I agree with most of the column, there is a secondary issue, which is close to my heart, I would like to react to. And I certainly concur with the last sentence of the column which starts with "This should involve the quant community in an active role" as this has also been my opinion for a long time.

I would nevertheless like to present a different perspective on some side elements of their argument. To my opinion, the expanded use of overnight benchmarks will (should) not reduce the multi-curve complexity.

The pre-2007 single curve "simplicity" was coming from a combination of error and domination. Error in confusing two effects, the (pseudo-)discounting and the reference benchmark. This error was helped by the domination of a rate family: the IBOR benchmarks — the LIBOR king. The crisis emphasised the difference between the overnight benchmark used for collateral remuneration and the IBOR benchmarks and lead to the overnight discounting. A second crisis impact is that the king is dying.

Moving to overnight benchmark as the dominant benchmark may simplify the valuation of vanilla instruments by simplifying the vanilla contracts(1); both the collateral/discounting and the reference benchmark will be the same. But it will only simplify the bank balance sheets on the vanilla derivative side, there is no guarantee that it will simplify the balance sheet globally. The funding term structure of a bank will become the LIBOR of tomorrow but without its liquidity. The generalised VM/IM and its associated costs has pushed the funding issue into the valuation of derivatives (FVA, MVA). There is no need to see the LIBOR or the funding cost to appear directly in the instrument term sheet to need it in derivatives valuation.

I certainly concur with the authors that transition to new benchmark could be an opportunity to review models related to funding but I don't think it will reduce multi-curve complexities. It may lead to a name different from Multi-curve Framework, but the issue of different curves to be used for different purposes will continue to be relevant, maybe even more so with the introduction of new benchmarks. Maybe it will be called the Funding Framework(2).

Even if I concur with the authors that the transition could be an opportunity, I'm afraid that the market will have its back against the wall due to time and regulatory constraints — like in the margin changes case —, that only the minimal to survive will be realistically achieved and that the bank managements, market associations and regulators will not let the quant community play an active role.

Like for other similar issues, I sincerely hope that I will be proved wrong on the quants involvment. Don't hesitate to let me know that I'm wrong, I will enjoy it.

Don't hesitate to contact me for projects on the subject of benchmarks transition.

(1) Contract here as to be understood as a combination of the specific instruments term sheet and the generic master agreement, which govern the now mandatory associated daily variation margin.

(2) By the way, this was the name I used in my March 2007 paper on Discounting Irony, the first paper on what is today called multi-curve framework.


SOFR and clearing

The two main clearing houses for USD OTC interest rate contracts (LCH and CME) have announced that they will start clearing SOFR indexd swaps in the third quarter of 2018.

The announcement was discussed in the following Risk.net article: LCH and CME to start clearing SOFR swaps in third quarter.

Even if the clearing of SOFR swaps becomes available, users will have to wait a while for the full effects of the new rate to appear in the market. As envisaged by the Alternative Reference Rates Committee (ARRC), the Fed Funds rate will continue to be used to calculate the price alignment interest, i.e. to pay the interest on the variation margin.

This means that for the moment, one would not be able to price and risk manage SOFR OIS without having a full term structure of the Fed Funds OIS. The SOFR OIS will move from the status of non-existence to the status of second class citizen of the OTC market world, but not yet to first class citizen.

This is not a surprise as the transition from one benchmark to another is a very difficult task, the difficulty of which is well documented, in particular on this blog.

From a SOFR's derivative perspective, it means that there will be two type of derivatives, the one collateralized a zero rates (futures) and the one collateralized at fed fund rates (OTC OIS). And we will be waiting for the third type, collateralized at SOFR to appear soon.

In term of valuation, it means a multiplication of convexity adjustments. In a recent blog and working paper, I mentioned the adjustments between overnight futures and OIS collateralized at the OIS index. The situation proposed by the hybrid rate approach will require further adjustments. This may be the subject of further blogs and working papers. It will take time to develop as we need a good multi-curve model with multiple discounting and a meaningful understanding of the join dynamic of Fed Funds and SOFR.Very soon we will have, just for overnight rates in USD 2 forwards and 3 discounting. With a couple of weeks of history on the SOFR fixing and no related derivatives today, we are very far away from having that understanding. It is of note also that the secured rate SOFR is fixing above the unsecured rate Fed Fund and also that the spread has gone from 13 basis points to 4 basis points in a couple of weeks.

It will also soon be time to offer for trading the rate quoted overnight indexed futures that I proposed some years ago. If they were traded on SOFR and the OTC clearing was done based on SOFR collateral rate, they would allow to create a full term structure with a unique design from 1 month to 30 years. It would also have very little convexity adjustment wrt OTC products, a lot less than the current offering based on 3 month futures traded with expiry up to 5 years. Don't hesitate to contact me for more detail about that design.


Overnight indexed futures

With the recent changes in market infrastructure and in the regulatory framework the importance of overnight benchmarks has increased in the last years and is expected to increase further. With that increased importance, the market will look for source of liquidity for overnight based derivatives beyond the traditional OIS. In its document on SONIA as the RFR, the The Working Group on Sterling Risk-Free Reference Rates calls for the development and promotion of interest rate derivative products which reference the RFR, including the design of a futures contract.

At a couple of days interval, CurveGlobal and CME have announced their plans to launch new overnight benchmark based futures. In the case of CurveGlobal, the futures is called Three month SONIA futures. The launch is planned for Q2 2018. In the case of CME the futures is called CME Three-Month SOFR Futures. The launch is planned for 7 May 2018. The CME futures is based on the Secured Overnight Financing Rate (SOFR). The SOFR rate is published by the Federal Reserve Bank of New York in cooperation with the U.S. Office of Financial Research. The rate publication started on 2 April 2018 and was discussed briefly in two previous blogs (here and here).

In a recent working paper, I describe the detailed futures instrument cash-flow and propose the pricing, including the convexity adjustment, of the new instrument in the collateral framework using a Gaussian HJM-like model. The paper is called

The adjustment obtained is relatively similar to the one obtained for LIBOR futures (see for example Eurodollar Futures and Options: Convexity Adjustment in HJM One-Factor Model) when the stochastic nature of the LIBOR/OIS spread is ignored. Some extra small adjustment need to be added to take into account that the futures settles only at the end of the accrual period while the LIBOR futures settle on fixing at the start of the underlying deposit period.

This futures is a new products that may help to bridge the gap between OTC and ETD in the overnight indexed products. It has still several inconvenient features that makes it difficult to be used as a building block to build an overnight yield curve up to 30 years as required by the market. Most of those drawback would be solved if the market was to adopt a design closer to the one I proposed some years ago.

I will continue to preach for the alternative design and don’t hesitate to contact me if you are interested by my sermon!


SOFR one week on

The Secured Overnight Financing Rate (SOFR) has now been published by the Fed New York for a week. Time for an early analysis.

The data published does not only consists of the benchmark rate itself which is a median rate of the data collected, but also the 1, 25, 75 and 99% percentiles. From that information, we can see that 50% of the rates captured are outside a 10 basis points band around the published rate. For the Effective Fed Fund Rate (EFFR), the 50% band is only 2 bps.

What is the origin of this larger dispersion of rates for the SOFR rate? Maybe the daily publication of the figures will increase transparency in that particular market which will lead to the narrowing of the dispersion? We will see if this is the case in a couple of months.

Another type of explanation for a larger diversity of rates could be the existence of a bid-offer in the SOFR underlying data. The Effective Fed Fund Rate is calculated on overnight federal funds transactions, which means that the transactions used are interbank transactions, transaction between are relatively homogeneous set of participants. On the other side, the SOFR transactions also include trades with clients and market-takers. The set of participants is less homogeneous. Could this 10 basis point difference be explained by bid-offer?

On a different subject, note that between the 3 April and the 4 April, the SOFR went down by 9 basis points while the EFFR was unchanged; the spread between SOFR and EFFR decreased by 9 basis points.

The spread between SOFR and EFFR is currently at 6 basis points. The secured rate still well above the unsecured rate!

The page on the Fed New York website with data related to SOFR is:

The page on the Fed New York website with data related to Federal Funds Effective Rate is:


SOFR published

The first value of the Secured Overnight Financing Rate (SOFR) benchmark has been published today by the New York Fed. The page for the rate is: https://apps.newyorkfed.org/markets/autorates/sofr

A new benchmark that is expected to play a role in the Games of Benchmarks.

The first value of the benchmark, for overnight rates between Tuesday 2 April and Wednesday 3 April, has been fixed at 1.80%. For the same period, the Fed Fund Effective rate has been fixed at 1.68%.

This means that the secured rate is 12 basis points above the unsecured rate!

Note that like for some other overnight rates,  the new benchmark is based on rates for trade on the start of the overnight period but only published the next day. It is difficult to understand why, in this era of real time and supercomputers, it takes so long for the publication of the rate. Even LIBOR that is probably not a paragon of virtue was published as soon as computed, around 11:00 a.m. London time. Note that SONIA, when it will be moved to its reformed version on 23 April 2018, will also be only published on a next day basis. Personally I would prefer an immediate publication. But it seems that timely publication is not a requirement for benchmarks.


Variation margin in presence of trade cash flows

A couple of years ago, I have posted a blog called Continuous dividend v cash flows.

With the generalisation of Variation Margin (VM) collateral, the derivative world is not driven anymore by discrete cash flows but by continuous dividend. Due to practical constraints, the VM is paid with a one day delay. This delay reduces significantly the effectiveness of the margin process as credit risk exposure reduction mechanism around the trade cash flow payments. The above blog presented an efficient and simple approach to bring back the effectiveness of the VM process even around trade flows dates. The approach is based on the usage of a forward valuation in the VM computation process.

Since then, the research related to the spike of counterparty exposure has earned to its authors the Quant of the Year award. In the award winning paper (Does initial margin eliminate counterparty risk?), the authors have introduced my proposal in one of the conclusion paragraph.

In its Guide on assessment methodology for the IMM and A-CVA, the ECB has also put as special emphasise (Part 4, Chapter 7, 43.(3).(e)-(g)) on looking at this issue.

As the issue is gaining more attention, I though it would be useful to republish the blog, with minor updates, as a working paper. The document can now be found on SSRN: Variation margin in presence of trade cash flows.


Change of benchmark overnight index is a difficult task: 2017 year-end review

Is SARON, as of 1st January 2018, the CHF benchmark for all OIS trades and all CSAs? Has TOIS been discontinued at the same date?

If no, please read my blog from February 2017 and its follow-ups.

If yes, I apologize for my doubts and congratulate the CHF market for that amazing achievement that I though was impossible.

Blog written on 27 February 2017 and scheduled to be published on 1 January 2018.