A PROJECT REPORT FOR SOFR Derivatives

Abstract

The objective of this study was to identify the detailed situation and practical
application of SOFR, which is compared with LIBOR.

In order to make up for the defects of LIBOR, FED established ARRC to look
for alternative interest rates, and proposed three characteristics that alternative interest
rates must have: based on the market with high daily trading volume, high liquidity,
more active and stable; it must be risk-free or approximately risk-free; it is not to
impose restrictions on US monetary policy. In line with this requirement, ARRC
chose SOFR among the following options (overnight unsecured rate, general
mortgage rate, policy rate, Treasury rate, term overnight index swap (OIS) rate, term
unsecured rate).

To get smooth progress, theoretical analysis and empirical analysis are mainly used.

Key Words: SOFR, LIBOR, AARC, derivatives, SOFR futures, SOFR options,SOFR
OTC contracts.

Introduction

According to the definition of FED, SOFR (Secured Overnight Financing

Rate) is a broad measure of the cost of borrowing cash against overnight collateral of
treasury bonds.

SOFR derivatives includes all transactions with a broad general collateral rate,
as well as cleared bilateral treasury repurchase agreements through a delivery and
payment (DVP) service provided by a fixed income clearing company, which is
screened to remove some transactions deemed to be special offers (Lexology, 2020).

ARC's full name is Alternative Reference Rates Committee, and IOSCO is the
abbreviation of International Organization of Securities Commissions (Goldman
Sachs, 2020).

According to the website of ARRC, FED ( the Federal Reserve System) led
the formation of ARRC in 2014. ARRC is composed of the Board of Governors of
FED, the New York Branch of FED, and other financial institutions. In the early days
of the reform, ARRC discussed a lot about how to create a new set of alternative
reference rates based on the real market and finally decided that a new benchmark rate
formation mechanism should be based on the actual transaction data to the maximum
extent and reduce the possibility of manipulation. In November 2017, ARRC
officially selected the SOFR (Overnight Secured Financing Rate) as the benchmark
for the new US financial markets.

According to the website of IOSCO, IOSCO is a securities regulatory

international organization, with a “club” nature. It was founded in 1983, and the office
is based in Madrid, Spain. It was born as a regional organization of the Americas in
1974. The aim is to develop international coordination, exchange information,
establish adequate investor protection, and provide mutual assistance for effective
regulation and management. IOSCO has 181 members, covering 90% of the global
equity market.

LIBOR is the overnight risk-free rate, with different types of spread quotes.
The 20 Banks chosen by the British Bankers' Association are quoted their LIBOR
rates by 11:00 London time in each trading day, with the middle 10 quoted
arithmetically averaged (BIS,2020). Since this quotation is not based on real market
transactions, it cannot accurately reflect the actual situation of inter-bank funds rate.
Less than $500m a day in daily trading at the LIBOR benchmark rate affects more
than $200tn in financial products, of which about $3.4tn is in commercial loans and
about $1.3tn in mortgages and other consumer credit.

Since the release of SOFR rate in April 2018, market traders have actively
participated and the activity of related assets has increased significantly (JP Morgen,
2020). The volumes of SOFR futures contracts have increased steadily, and
exchanges have begun clearing SOFR swaps. Besides that, Us banks have embarked
on a floating rate bond issue linked to SOFR.

In the UK, LIBOR is replaced by SONIA, measuring the cost that banks pay
to borrow overnight. It is a revised average of overnight, unsecured and wholesale
rates. SONIA was first introduced in 1997 and has been around for a long time in
Britain's financial markets.

In September 2016, the European Money Market Institution (EMMI) tried to

cultivate a new benchmark interest rate by reforming Euribor, but the effect was
unsatisfactory. Later, it focused on the reform exploration of the overnight index
average of Euro (EONIA), which failed to meet EU’s relevant requirements on
benchmark interest rate in terms of soundness.

SOFR Futures and options

According to SEC, ARRC has proposed a six-step timeline for moving

forward with the replacement of US dollar LIBOR, and the work is currently well
underway, ​as illustrated in following figure:

ETC Job content Schedule

Step 1 Q2 of 2018 Build the infrastructure Finished. SOFR futures were
needed to the exchanges of launched on 7 May 2018 by
SOFR futures and OIS CME (Chicago Mercantile
overnight index swaps Exchange ).
Step 2 The end of Start trading in SOFR Finished. London Clearing
2018 futures and bilateral House cleared the first
non-centrally cleared OIS BATCH of SOFR swaps on
linked to SOFR 18 July 2018.
Step 3 Q1 of 2019 A central clearing OIS
started with a transaction
linked SOFR, still using
EFFR to calculate
Price-adjusted Interest
 (PAI) and discount.
Step 4 Q1 of 2020 Central Counterparties Finished. The clearing of
(CCPs) began to take over SOFR swaps will begin on 1
swaps and contracts that is October 2018 by CME.
calculated by PAI and
discounted on SOFR, but
also allowed market
participants to use EFFR
and SOFR to calculate PAI
and discounted on their
own.
Step 5 Q2 of 2021 CCPs will no longer use LCH and CME converted
EFFR to calculate PAI and their discount curves to
discount rates unless it is SOFR curves on 16 October
used to settle or reduce 2020. LCH announced that it
EFFR's legacy risks in old expects to increase its swap
contracts. contracts based on PAI and
discount rate of SOFR in the
second half of 2021.
Step 6 The end of Based on the full FCA will no longer push or
2021 development of SOFR force Banks to provide
derivatives liquidity, the LIBOR submissions until the
forward yield curve is end of 2021.
established.

Under the CME’s proposal, when LIBOR is officially announced, an automatic

conversion of all open Eurodollar futures into SOFR futures would be triggered, with
price adjustments to reflect the difference between the two contracts.

Such contracts are called Eurodollar futures because they were originally
linked to dollar deposit rates outside the US, particularly in Europe. Its price
movements are based on market expectations of the future value of LIBOR.
Eurodollar futures can therefore be used to bet on the movement of LIBOR and to
hedge the risk of LIBOR volatility.

This transition will affect a variety of companies and institutions that use
Eurodollar futures.These include hedge funds betting on changes in FED policy with
Eurodollar futures, and banks that use Eurodollar futures to protect themselves from
rising interest rates when they lend.

In terms of the actual operation, the volume of SOFR futures is increasing and
its market attention is increasing. Since SOFR futures are highly correlated with
benchmark Eurodollar and Federal funds futures, SOFR futures can be used to hedge
the risk of the interest rate changes, especially the risk of financing interest rate
changes represented by Treasury bond repurchase rate. Examples of specific
applications are in the attached list, so as SOFR options. PS: for the convenience of
calculation, the SOFR values are not true.

SOFR OTC Contracts

OTC is the short name of over-the-counter. It is the market in which securities

are bought and sold through a large number of dispersed securities dealers such as
investment banks and major telecommunications facilities. Securities bought and sold
in the OTC are mainly Treasury bonds (Third way, 2020).

A number of challenges remain to successfully complete the replacement of

the base rate and make the SOFR widely accepted by market participants, especially
for the forwards and swaps. Firstly, SOFR is a newly constructed interest rate. The
establishment of derivatives priced by reference to SOFR requires certain liquidity,
and market participants will also consider the liquidity of derivatives when choosing
the reference interest rate of spot products.Secondly, SOFR is the overnight rate, and
ARRC is required to complete the construction of a full term structure rate by the end
of 2021.

According to ISDA's latest backup plan, one possible option is to replace the
original LIBOR rate with a specific spread over the SOFR, allowing unmatured trades
to mature smoothly.In addition, the counterparty holding the outstanding transaction
may reach a new solution through private negotiation (such as negotiation for early
termination).

Summary

In order to write this essay, I have reviewed a large number of literatures, but
at present I can find only a few literatures on SOFR, and only have a preliminary
understanding of the concept, history and mechanism of LIBOR and SOFR, among
which the application of SOFR futures and options is a difficulty. In the next research,
we will continue to strengthen the interdisciplinary literacy of finance and
mathematics, and consult more literature on the practical application of SOFR.

References

Board of the Governors of the Federal Reserve System, 2020.​What Happened in

Money Markets in September 2019?.​ [online] Available at:
<https://www.federalreserve.gov/econres/notes/feds-notes/what-happened-in-mo
ney-markets-in-september-2019-20200227.htm> [Accessed 14 Nov 2020].
Lexology, 2020.​ LIBOR Replacement Begins Publication. [​ online] Available at:
<https://www.lexology.com/library/detail.aspx?g=10097c0f-7207-47d9-ad96-fef
11f2006db> [Accessed 14 Nov 2020].
Goldman Sachs, 2020. ​Breaking Up Is Hard To Do: LIBOR’s Transition. ​[online]
Available at:
<https://www.gsam.com/content/gsam/us/en/advisors/market-insights/gsam-conn
ect/2018/breaking-up-is-hard-to-do_LIBORs-transition.html> [Accessed 14 Nov
2020].
ARRC, 2020. ​Governance of the ARRC. [​ online] Available at:
<https://www.newyorkfed.org/arrc/about> [Accessed 14 Nov 2020].
BIS, 2020. ​Beyond LIBOR: a primer on the new benchmark rates. [​ online] Available
at:
<https://www.bis.org/publ/qtrpdf/r_qt1903e.html> [Accessed 14 Nov 2020].
OICU-IOSCO, 2020. ​About IOSCO.​ [online] Available at:
<https://www.iosco.org/about/?subsection=about_iosco> [Accessed 14 Nov
2020].
JP Morgen, 2020. ​LIBOR Primer: Setting the Stage for SOFR. ​[online] Available at:
<https://www.jpmorgan.com/solutions/cib/markets/libor-sofr> [Accessed 14 Nov
2020].
SEC, 2020. ​Staff Statement on LIBOR Transition. [​ online] Available at:
<https://www.sec.gov/news/public-statement/libor-transition> [Accessed 14 Nov
2020].
Third way, 2020. ​The Bond Market: How it Works, or How it Doesn't. [​ online]
Available at:
<https://www.thirdway.org/report/the-bond-market-how-it-works-or-how-it-does
nt> [Accessed 14 Nov 2020].