The Case for Wider Use of Term SOFR
In my last paper I looked at the trends in USD derivative turnover from BIS Triennial Surveys 2010 – 2022. In this paper I focus on the 2022 Survey and how it supports the wider use of Term SOFR than is currently permitted under existing use limits.
Many of our clients have concerns that SOFR is difficult to use compared with LIBOR. Most of their issues are related to operational problems, forward cash management and accounting calculations. LIBOR, as a forward-looking rate allows clients the time to manage their processes before settlement, whereas SOFR is a daily update which causes additional effort and forecasting. Term SOFR appears to be an easier transition as it shares many of the more desirable attributes of LIBOR.
Simply put, Term SOFR presents an easier transition from LIBOR than is compounded SOFR: CME’s own data tends to support this.
In the past I have looked at the use case for Term SOFR. Risk.net has published on this topic a few times in 2021, 2022 and 2023 outlining the various rules which are currently restricting the use of Term SOFR.
While many people, including myself, support the ARRC and Fed view that widespread use of Term SOFR may be problematic, I also believe that some easing of the restrictions may benefit end-users and not present systemic risks. This is supported by the Survey results as I explain below.
This paper looks at the 2022 BIS Triennial Survey for a breakdown of the users of SOFR and LIBOR. We can reasonably assume the LIBOR users will become SOFR users after 30 June 2023 (i.e., LIBOR cessation) so we can look at the total as a reasonable approximation of market turnover and user mix for SOFR.
Also, we could assume SOFR turnover is at or probably greater than in 2022 based on the trend in USD turnover to higher turnover over the past 10 years.
Firstly, let’s look at the product breakdown per participant grouping.
Turnover of USD derivatives by market participant groups
The Survey does provide some breakdown of the turnover of USD per market participant type. The trades are reported by Reporting Dealers and they separate their trades with other counterparties as follows:
Reporting Dealers – other banks reporting turnover;
Other Financial Institutions – financial institutions which are not Reporting Dealers (e.g., investment funds); and
Non-Financial customers – End users not included in the 2 groups above (e.g., corporates).
There may be derivative transactions between firms who are not Reporting Dealers: these trades would not be included in the Survey. Such trades could be between Other Financial Institutions so their market share may be even larger than that in the Survey.
The following chart shows the breakdown and the market percentage of each group.
The main points I see here are:
Overnight Index Swaps (SOFR) and LIBOR derivatives have comparable turnover.
Other Financial Institutions are the dominant payers with 80% of the total (SOFR + LIBOR) turnover.
Trading between Reporting Dealers is19% of market turnover and considerably less than the trading between Reporting Dealers and Other Financial Institutions.
Trading with Non-Financial customers is a minor part of market turnover and only represents 1% of the market.
Where is the turnover located?
USD is the largest derivative currency by turnover in the Survey as shown in the following chart.
Focusing on the USD, the turnover per country is varied as shown in the next chart.
USD derivatives are predominately traded in USA and UK with some turnover in other countries as well.
Conclusions from the Survey
The 2022 Survey is very clear that:
USD derivative trading is the largest by currency (44%).
The majority of that trading is in USA (68%) followed by UK (24%).
Trading between Reporting Dealers and Other Financial Institutions dominated the trading (80%).
Trading between Reporting Dealers and Non-Financial customers is a very minor component (1%).
As the USD derivatives markets, and presumably debt markets, move from LIBOR to SOFR, I reasonably expect the four points above to continue to be relevant.
How does this impact the use of Term SOFR?
The ARRC and Fed have reiterated their view that the use of Term SOFR should be restricted to a narrow range of products as described by Risk. The CME license terms for referencing Term SOFR reflect the ARRC recommendations and effectively prohibit using derivatives except between dealers to customers to hedge Term SOFR debt to a fixed rate.
The reasons provided by ARRC include to restrict the use of Term SOFR include:
avoiding a repeat of LIBOR with Term SOFR;
inter-dealer trading of Term SOFR could grow rapidly if permitted; and
trading Term SOFR could cannibalise trading SOFR itself.
The main fear is that easing restrictions on Term SOFR to allow for more use by end-users could unleash a torrent of inter-dealer and dealer to customer trading.
The 2022 Survey results do not appear to support this if trading Term SOFR had some restrictions to support dealer-customer and limited dealer-dealer trading.
The trading with end users in LIBOR (no restrictions and the vast majority of this trading based on my last paper) and/or SOFR (minimal in 2022) is only 1% of total market turnover in USD derivatives.
If all the LIBOR trading for Non-Financial customers is replaced by Term SOFR then it still only represents 1% of the market.
If interbank trading of Term SOFR was allowed (under certain restrictions) then it may also be around 1% of the market to clear offsetting risks between dealers.
So, even with a relatively unrestricted approach to allowing Reporting Dealers to trade with Non-Financial customers, the percentage of market turnover could be expected to be in the 1% – 2% range which unlikely to create a systemic problem if Term SOFR is discontinued sometime in the future.
Summary
The BIS 2022 Triennial Survey has many interesting features.
Among these is the interesting fact that trading between Reporting Dealers and Non-Financial customers is approximately 1% of market turnover in USD derivatives.
This has important implications for the use case for Term SOFR.
If trading in USD derivatives referencing Term SOFR is restricted to Non-Financial customers, then it is likely to be similarly around 1% of USD derivative turnover if all LIBOR and SOFR trading references Term SOFR.
This is not significant and would be unlikely to present systemic issues if Term SOFR was discontinued at some time.
Of course, contracts referencing Term SOFR would have fallbacks to accommodate a permanent cessation of Term SOFR.
I believe there is a good argument to allow wider use of Term SOFR for end users. A moderate relaxation of the CME licensing rules would allow a more balanced market (i.e., Term SOFR to fixed and fixed to Term SOFR derivatives) and address the reasonable concerns of the end users in the transition from LIBOR.