2019 SOFR Ecosystem Recap

Growth across markets

Throughout 2019, adoption of the Secured Overnight Financing Rate (SOFR) continued to experience rapid uptake, establishing itself as the consensus alternative US reference rate.  Increased awareness of the benchmark, participation in the floating rate note market, and clearing of OTC swaps complemented the buildup in futures liquidity, with more market participants hedging against short term rate uncertainty.

FOMC policy and repo volatility

The Federal Reserve reversed course on its Federal Funds target rate during 2019, with three of the four 2018 hikes negated this past fall.  The mid-September spike in overnight repo rates of more than 280 basis points also drew increased attention, and the month ended with a spike of 53 bps, more aggressive than the typical 20-30bps driven by liquidity needs.

This sudden volatility in short-term interest rates drove futures trading to new highs and validated CME SOFR Futures as a useful risk management tool for managing funding risk.  In September, daily volume rose to more than 58,000 contracts, with open interest jumping from around 282,000 to 429,000. 

Inter-commodity spreads also took off in the second half of the year, drawing on extensive CME liquidity pools in the Fed Funds futures (spread against SR1) and Eurodollars (against SR3).  During the fall volatility runup, average ICS volume reached 25-35% of total SOFR futures trading.

All told, Q4 of 2019 saw average daily volume rise to 42,000 contracts, from just 11,000 a year earlier.  Open interest similarly rose to 482,000 contracts from 53,000.  Expressed in DV01, the dollar value shift for a single basis point move in price, this represented nearly $150 million in daily risk transfer.

As market liquidity grew deeper, it also broadened.  Large Open Interest Holders, the CFTC’s measure of market participants with significant positions, jumped from 65 at the end of 2018 to 161 in 2019.  This expansion ensures major hedgers have a variety of potential trading partners available.

Floating rate note issuance

2019 also saw a takeoff in floating rate note issuance, with consistent participants such as the US government-sponsored enterprises and major commercial banks joined by an increasing number of smaller and international financial institutions.  In all, 45 parties including two dozen banks issued more than 300 notes totaling $277 billion, a nearly tenfold increase over 2018’s activity.

Multiple institutions also signaled their shift toward SOFR as a new benchmark, from the 11 Federal Home Loan Banks adopting SOFR for all issuance past 2021, to Royal Dutch Shell’s $10 billion SOFR-linked revolving credit facility, to Freddie Mac’s launch of the first commercial mortgage bond tied to SOFR.  These moves reflected an increased appetite for overnight rates, and signaled a growing need for risk management around a rate calculated in arrears.

OTC swaps

Swaps referencing SOFR began trading and clearing much more frequently in 2019, in particular towards the end of the year.  In total during 2019, CME cleared over $44B in swaps referencing SOFR, with a record $21B cleared in December 2019.

In 2020, we look for this liquidity to develop further as CME moves from determining the discounting and price alignment amounts for existing USD cleared swaps from the current EFFR rate to SOFR on October 16th, 2020.  This is a market-coordinated event which will be watched closely by all those involved in these markets.

Next developments

With the first full year of SOFR futures trading complete, 2020 holds several developments which promise to further develop the ecosystem.  Options on the Three-Month contract went live on January 6, several major debt issuers including the FHLBs plan to shift to SOFR as their predominant USD benchmark, and the availability of term rates is widely anticipated, all bolstering the need for hedging and availability of liquidity in the futures market.

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