Derivatives and USD Term Rates
This article continues the series on the practical uses of term risk free rates (Term RFRs) in USD. Previously, Ross and myself have both looked at the USD term rates where we are seeing significant interest in Ameribor, AXI, BSBY, Term SOFR, CRITS and CRITR. They all have uses and many market participants are actively looking at the way these new reference rates can complement[RB1] compounded SOFR and provide a more appropriate solution to their requirements.
In this article I look at derivatives and how these important hedge products are being introduced into markets referencing the term rates.
Derivatives referencing compounded SOFR
The market for interest rate swaps and cross-currency swaps referencing compounding SOFR is well established now and supported by price-makers and some end users.
However, the basis swap market is still developing with some swap pairs liquid while others are less so. Examples with significant liquidity include:
USD LIBOR/SOFR; and
Fed Funds/SOFR.
Some examples of developing markets with identifiable pricing include:
BSBY/SOFR; and
Ameribor/SOFR.
Other reference rates such as AXI, CRITS and CRITR have some pricing transparency, but it has been somewhat more difficult to quantify at this early stage.
Basis swaps are not static and can vary considerably. The chart below shows the last 11 months (since BSBY has been available) of the USD SOFR versus other reference rates. Since there is some volatility (noting Fed Funds is on the secondary axis) many users may wish to hedge the exposure!
Basis swap markets are essential and provide different market participants the ability to transform their current risks to something more appropriate. For example, the combination of a fixed-rate debt issue by a corporate could be converted to and Ameribor reference by a combination of a Fixed rate to SOFR swap and a SOFR to Ameribor basis swap.
Of course, this can be delivered by a bank in a single swap, but the pricing would typically use the combination if a fixed swap and a basis swap to achieve the outcome for the corporate and a hedge in the inter-dealer market.
Derivatives referencing Term SOFR
Derivatives referencing Term SOFR are available for end-users. An active and available derivatives markets is essential to provide effective hedges for loans, debt issues and investments.
But there is a catch: the inter-dealer market for Term SOFR derivatives does not yet exist. Risk.net has a great article on this problem titled ‘Term SOFR restrictions spark valuation debate’. The Fed and ARRC guidelines restrict the use of Term SOFR derivatives and effectively do not allow inter-dealer trades.
This means dealer books can be one-way with the end-holders and there is no way to clear this risk in a similar way to other derivatives: i.e., hedging with other dealers with opposite positions or views.
There are no on-screen prices, so dealers are obliged to use internal models to replicate the valuation curves. While this is somewhat trivial (with the Term SOFR and compounded SOFR forward curves theoretically identical) there can be small differences due to hedging, collateral and one-way adjustments which need to be considered when building the curves.
In addition, if Term SOFR derivatives cannot be identically hedged then they may be consigned to the ‘structured’ book within the dealer firm and attract additional reserves and capital.
Either way, the absence of the interdealer market is very real and has consequences for all market participants who may use these derivatives.
Why does the absence of an inter-dealer Term SOFR derivatives market matter to end-users?
It matters for at least 2 reasons: cost and availability.
Firstly, dealer costs would very likely be higher for Term SOFR than for compounded SOFR. This is based on the provisions in the structured book and the higher capital applied to the trades. These costs will be passed on to the end-users.
Secondly, as dealers develop larger one-way books then internal risk limits may start to restrict the number and size of additional trades that can be added to the book.
The inter-dealer market could address both issues by allowing dealers to offset the risks with each other. If this cannot happen, then end-users must expect greater cost and potentially product restrictions and shortages which will likely lead to price inflation (which is quite topical in the economic sense).
What are we observing and hearing?
There is very clear demand for term rates from many buy and sell side consumers of reference rates. The reasons for the preferences of term rates over compounded SOFR are varied and include:
Current processes for operational management are difficult when you only know the refence rate at the end of the period.
Cash management is done well in advance for many firms and arranging for settlements and cash needs more than a few days to organise.
Accounting and planning processes are normally conducted when the rates and cashflows are known in advance of settlement.
Changes to interest rates (e.g., the recent Fed tightening) during a period can impact the costs and make planning for offsetting income more difficult to anticipate.
We often hear the expression ‘need or want’ applied to term rates. While many system issues can be resolved and remove part of the ‘need’, many process and planning issues remain and still represent a considerable ‘need’ as well as ‘want’.
Summary
The Term rates are gaining in popularity and use as more market participants appear to find them appropriate for their businesses. The loan and debt markets are expanding their use of term rates, and this shows no signs of slowing.
But there could be additional costs and restrictions. End-users will have to weigh the costs against the benefits for term rates in many processes and situations where they are appropriate.
Sell-side firms will likewise have to carefully consider how they price and manage the term rate risks while still offering a competitive product to their customers.