On July 12, the Commodity Futures Trading Commission hosted a meeting of its Market Risk Advisory Committee in Washington, D.C. to discuss the transition from the Libor benchmark used in U.S. dollar-based interest rate markets to a more robust alternative known as the Secured Overnight Funding Rate or SOFR, and the implications of this multi-year transition for derivatives markets.
“The discontinuation of Libor is not a possibility. It is a certainty,” said CFTC Chairman Chris Giancarlo. “We must anticipate it, we must accommodate it, and we must adapt to it."
The day-long meeting primarily focused on the transition away from Libor and the efforts to establish SOFR as an alternative. However, CFTC Commissioner Rostin Behnam, the advisory committee's sponsor, invited members of the committee to recommend other topics for future discussion. Several committee members cited concerns about issues relating to central counterparty clearing. These included the amount of capital, or "skin in the game", that the clearinghouses contribute to their default protections, the need to incentivize more banks to provide clearing services particularly for market makers, and the need for more comprehensive testing of cybersecurity protections at clearinghouses. Several committee members also cited concerns about the growing influence of artificial intelligence in both trading and market surveillance and urged Behnam to add that topic to the committee's work agenda.
Sebastiaan Koeling, head of Optiver US, who was speaking on behalf of the FIA Principal Traders Group, put a particular emphasis on the impact of bank capital rules, notably the supplemental leverage ratio, on the availability of clearing services. He urged the committee to consider the harm to the market makers that provide liquidity in the exchange-traded derivatives markets.
Transition from LIBOR to SOFR
During the discussion on the transition from Libor to SOFR, officials flagged a number of important issues that must be addressed in both the short- and long-term to achieve an orderly transition. But there was a consensus that considerable progress has already been made, including the identification of SOFR as a suitable replacement, the publication of historical data to help market participants to model the new rate, and the introduction of trading and clearing services for SOFR-based derivatives.
Thomas Wipf, vice chairman of institutional securities at Morgan Stanley and a member of the Alternative Reference Rates Committee convened by the New York Fed that is spearheading the transition, commented that market participants are embracing the concept of not "running away from Libor" but instead "running to SOFR" because of its advantages over Libor, notably a more robust underlying market.
"We've been describing this as the five stages of grief, and I think … over the last few years we've moved very quickly from denial and anger to a point of widespread market acceptance that there's work that needs to be done,” he said.
Representatives from CME and LCH discussed their plans to develop trading and clearing services for derivatives based on SOFR, including the launch of SOFR futures at CME in May, the launch of clearing services for SOFR swaps at LCH next week, and the launch of clearing services for SOFR swaps at CME in September.
Representatives from several leading banks and end-users discussed the challenges they face in migrating to the new benchmark and the need for deep liquidity in the new SOFR contracts. In addition, public and private sector officials involved in guiding the transition discussed areas where further work is needed. These areas included:
Curtailing the Issuance of New Libor Contracts: Despite warnings from global regulators that the benchmark will be abandoned in the coming years, some market participants are still issuing debt and derivatives that rely on Libor as the reference rate.
David Bowman, a senior advisor to the Federal Reserve Board's division of monetary affairs, commented that it is important to “stop the bleeding” and avoid making the existing workload worse. “Ultimately, we need to reduce the stock of contracts that reference U.S. dollar Libor if the risks are to be fully addressed,” Bowman said.
Adoption of SOFR: Agha Mirza of CME gave a presentation on the first few months of trading in the new SOFR futures and emphasized that there has been a very healthy level of trading activity. He noted that since the May launch more than 60 firms have participated in trading, more than 70,000 contracts have traded, and open interest going into the June expiration reached 12,000 contracts. He also emphasized the synergies with the rest of the interest rate complex at CME, including the opportunities for spread trading and margin offsets.
Although other participants in the meeting agreed that the new contract is off to a good start, they commented that liquidity is still relatively scarce and predicted that the market will not take off until SOFR is more widely used in the underlying markets for loans and securities. For example, some banks are considering the issuance of adjustable-rate mortgages based on SOFR, one person said. They also discussed the need to develop a term structure in the SOFR futures market so that market participants can use these contracts to hedge rate exposures going out for years.
Another set of issues that need to be addressed have to do with the CFTC's swap trading and clearing rules. Several participants noted that ARRC has drafted a letter outlining these issues, focusing in particular on the mandatory clearing and SEF trading rules, which may hinder the use of SOFR-based derivatives among market participants that prefer traditional methods of trading.
Still another set of issues surrounded the use of SOFR in calculating valuations and margin requirements. Specifically, it was mentioned that LCH is considering using fed funds for calculating variation margin and price alignment amounts on SOFR swaps, while CME has chosen SOFR for these calculations. Bill De Leon, managing director and global head of portfolio risk management at PIMCO, expressed support for the latter approach, but LCH's Phil Whitehurst noted that the fed funds rate is much more widely used, at least at the present time.
Cooperation and Urgency: CFTC officials and ARRC members were united in their desire to craft a comprehensive solution for the global financial system—and do so sooner rather than later. In fact, the CFTC meeting coincided with remarks from U.K. Financial Conduct Authority Chief Executive Andrew Bailey, who warned in a speech in London that “the pace of that transition is not yet fast enough.” Bailey also echoed concerns about both new Libor-based contracts and a need for fallback language.
At the same time, several participants expressed concerns about the discontinuance of Libor and the dangers of disruption to the large stock of swaps, loans, securities and other contracts that are likely to exist well into the future. Charles Schwartz, the head of derivatives at AXA Equitable, a large insurance company, explained that the discontinuation of Libor will affect not only the company's assets and hedges but also some of its insurance liabilities, and urged regulators to keep Libor in some form beyond the cut-off date of 2021.
"While we work toward transplanting the old heart of the financial system, Libor, with a newer and better heart, SOFR, let's make sure the patient stays alive on the operating table," said Schwartz.