By Karen Brettell
(Reuters) - The CME will launch next week futures based on a new benchmark rate published by the Federal Reserve, but investors may be slow to embrace them after unexpected volatility and a calculation error led to a rocky start for the new rate.
The CME Group’s (O:CME) launch of the contracts tracking the Secured Overnight Financing Rate, or SOFR, is part of a multi-year effort to move around $200 trillion in U.S.-dollar based derivatives and loans away from the use of the London interbank offered rate (Libor) as a benchmark. Cleared interest rate swaps based on the rate are also slated for this year.
Regulators including Fed Chairman Jerome Powell have warned that Libor could pose systemic risks in the event it stops being published due to the sheer size of markets based on the rate.
Still investors are also not yet comfortable with SOFR, which the New York Federal Reserve only began publishing on April 3.
“It doesn’t feel like there is a great reason to get involved whole hog right away with these futures,” said Thomas Simons, a money market economist at Jefferies in New York.
Libor is fragile as a decline in loans between banks means that borrowing rates are often estimated and not transaction-based. The benchmark also lost credibility after revelations that banks manipulated Libor submissions, in many cases to boost profits on their derivatives positions.
Analysts have expected SOFR to be more volatile than Libor as it is based on the overnight repurchase agreement market, which can have relatively large fluctuations that include declines in the middle of the month, and spikes at month-end that are exaggerated at quarter- and year-end.
Still, the rate has remained more elevated than many expected despite the Treasury’s repayment of Treasury bills as it received tax payments in April.(New reference rate has a choppy start: https://reut.rs/2rkqxMX)
“There is still a lot of volatility in the rate that I think is surprising on a daily basis. I think people don’t really feel like they totally understand it yet,” said Simons.
The New York Fed said on April 16 that forward-settling overnight repo transactions were inadvertently included in data that was provided to the bank to calculate the rate, though that problem has since been rectified.
Futures based on SOFR are expected to help develop a term market on the rate, which does not yet exist as the majority of repo transactions are overnight.
Term rates will offer a view on where the rate is likely to trade at fixed points in the future.
They are also crucial for increasing investor interest in the rate. Most loans and interest rate swaps are based on term rates such as three months.
“You want the market to start forming an opinion of what it will look like in six months or twelve months,” said Aaron Kohli, an interest rate strategist at BMO Capital Markets in New York.
However, "it’s very difficult for people to get a good idea of what this is going to look like in a few months when you really don’t have a good idea of what it's even going to look like in a few weeks," Kohli said.
While SOFR, unlike Libor, is based on a robust and liquid market, it remains to be seen whether asset managers will be reluctant to adopt the rate due to the absence of the credit component that Libor offers.
For SOFR to succeed “what we really need is some conviction in the marketplace that this is something that is really going to persist for a long term and that it’s a somewhat efficient way of expressing a view of what the forward rate is going to reset at,” Kohli said.