2018-04-22

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.

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