Asset and liability management (ALM) is a continuous source of tension for banks and credit unions. Borrowers typically want longer-term loans at fixed rates, while lenders would rather make floating-rate loans, since the loans are funded with short-term, variable rate deposits. This causes a duration mismatch. This dynamic occurs across all depository and lending entities–banks, credit unions and private lenders.
Not every balance sheet is the same, however. Some institutions are more sensitive to rates rising while others fear falling rates. In any case, a successful institution monitors interest rate risk (IRR) and proactively mitigates adverse rate movements that threaten to decrease its economic value or squeeze net interest margin.
But balance is necessary. Active IRR management must be carefully weighed against institutional strategy, competition and borrower demand. Eris SOFR Swap futures (Eris SOFR) from CME Group allow institutions the flexibility to price loans competitively without sacrificing net interest margin. In contrast to over-the-counter (OTC) interest rate swaps, Eris SOFR is a cost-conscious and simplified form of trading interest rate derivatives, without loss of hedge effectiveness.
Exchange-listed futures: Transparent, low-cost alternative to OTC swaps
Hedgers use Eris SOFR as a preferred alternative to OTC interest rate swaps. As futures contracts listed by CME Group, Eris SOFR offers market participants the economic performance of a standard, fixed-versus-floating-rate interest rate swap (IRS) and the advantages of using U.S. futures:
- Tighter bid/ask spreads reduce execution cost
Swap futures often trade between 1/8 and 3/8 of a basis point from mid-market levels. Users of swap futures report savings of one to three basis points on effective fixed rate, compared with OTC swaps. - Lower margin minimizes capital cost
Save 60% - 70% on margin relative to cleared swaps by reducing the amount of initial margin posted to collateralize swap positions. - Eligible for FASB hedge accounting
Banks and Credit Unions may use Eris SOFR Swap futures to reduce income statement volatility by applying fair value or cash flow hedge accounting. See this article for more information on hedge accounting. - No bank counterparty credit risk
CME Group is a central counterparty that stands between buyers and sellers of Eris SOFR Swap futures. If a futures clearing member defaults, its assets are auctioned within a 24-hour period to other clearing members, mitigating counterparty credit risk.
Hedging example: Eris SOFR for reducing bank duration gap
- EZ Bank (EZ) manages $5 billion in principal of 30-year fixed-rate mortgages.
- The duration gap between the mortgages and its short-term funding increases interest rate risk, negatively impacting EZ’s economic value as interest rates rise.
- To mitigate this risk, EZ elects to hedge 10% of the loan portfolio, selecting $500 million principal of mortgage loans with a weighted average life of 10 years.
- EZ evaluates its choices for hedging instruments: Bilateral OTC swaps, cleared swaps and Eris SOFR Swap futures.
- Eris SOFR versus bilateral OTC swaps: save on execution
For example, assume EZ executes an Eris SOFR hedge at a fixed rate 2.5 basis points lower than a bilateral OTC swap. If the dollar value of a basis point (DV01) is $400,000, then EZ saves $400,000 per bp times 2.5 bps or $1 million. Foregoing bilateral OTC swaps also reduces EZ’s counterparty credit risk. - Eris SOFR versus cleared swaps: save on initial margin
For example, if 5-Year cleared swaps require an initial margin (IM) of $23 million, only $9 million of IM is needed for Eris SOFR (calculated with CME CORE margin tool). With a lower margin requirement, EZ unlocked $14 million of capital. This could allow EZ to redeploy that capital back into the lending book or have additional funds on hand.
- Eris SOFR versus bilateral OTC swaps: save on execution
Did you know?
Regional banks and credit unions often trade OTC swaps 1-3 basis points from mid-market, compared with Eris SOFR, which typically trades within 3/8 basis points from mid-market.
Did you know?
Cleared swaps require up to 65% more Initial Margin (IM) than Eris SOFR.
Eris SOFR Hedged Portfolio (Example)
- EZ enters into a $500 million, 10-Year Eris SOFR Swap futures position (short; pay fixed, receive overnight SOFR), transforming the fixed-rate mortgage coupon income into floating-rate income, reducing the duration gap.
- Fair value changes from the mortgage portfolio layer (due to a change in SOFR rates) offset the changes in fair value of the swap futures position.
- The result is an offset both in interest and gains/losses:
- The economic value of EZ improves by $40 million, $80 million, $120 million and $160 million under the +100, +200, +300 and +400 interest rate scenarios, respectively.
- Interest from the mortgage portfolio offsets the interest from the swap futures.
Next Steps
- Ask your hedging advisor or futures broker how Eris SOFR can be used for ALM.
- Ask the product experts at Eris Innovations for more information.
- Visit erisfutures.com for additional resources.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
