An array of US bank notes
Last week $240bn of US dollar interest rate swaps based on Sofr were traded, according to ISDA © Bloomberg

Lenders have been slow to adopt the official substitute for the scandal-tarred Libor interest-rate benchmark, but derivatives traders are now giving it an enthusiastic welcome. 

Action in futures, options and swaps markets tied to the new secured overnight financing rate — Sofr — has shot up since the summer. These derivatives enable users to hedge against fluctuations in interest rates. 

Industry representatives picked Sofr in 2017 as an alternative to the London interbank offered rate, or Libor, the borrowing benchmark that was tarnished by a rate collusion scheme. Banks will be barred from underwriting new loans using Libor starting in 2022. 

Shifting market participants off US dollar Libor, the biggest and most important Libor rate, has been slow in part because Sofr had not been market-tested. The first Sofr-backed leveraged loan was not offered until earlier this month, more than three years after the Federal Reserve Bank of New York began to publish the rate. 

By comparison, the use of Sofr-linked derivatives is perking up. Last week $240bn of US dollar interest rate swaps based on Sofr were traded, equivalent to about 13.5 per cent of the total dollar Libor and Sofr market, according to data from the International Swaps and Derivatives Association. In June, Sofr-linked swaps accounted for only about 3 per cent of the market.

Volumes increased in part because of a regulatory initiative from the US Commodity Futures Trading Commission in July called Sofr First, aimed at the derivatives market. The programme switched derivatives pricing on some traders’ screens from Libor to Sofr.

“[Sofr First] was a big deal in terms of driving Sofr volumes across the Street. It’s more specific to swaps but it no doubt has also generated more hedging activity in futures,” said Mark Cabana, head of US rates strategy at Bank of America. 

At CME Group, the biggest US futures exchange operator, the number of outstanding contracts in listed derivatives based on Sofr has risen 90 per cent since the start of the year.

Column chart of Open interest in short-term interest rate options and futures, by rate (millions of contracts outstanding) showing Sofr moves to the main stage in derivatives markets

“The market has made far more progress in adopting Sofr and is much larger than we appreciate,” said Sean Tully, CME’s head of financial and over-the-counter products. “In the lending and the cash markets it is taking a bit longer. But in the derivatives markets, much more has happened.”

Libor is based on the interest rate at which banks say they would lend to other banks. Sofr is based on market transactions and represents the overnight cost to borrow cash backed by US Treasury debt. 

While Sofr may become popular in derivatives markets, its uptake in the loan market is not assured. Cabana said that bank lenders, as well as some companies, had indicated they didn’t believe Sofr was well suited for them. 

Unlike Sofr, credit risks are incorporated into Libor. When the risk associated with lending money increases during bouts of market volatility, Libor rises while Sofr moves less. Banks could therefore face the prospect of lending money at a steady Sofr rate while their own funding costs, which are linked to credit risk, are rising. 

“We believe we are going to be in a multi-reference rate environment where Sofr will initially be dominant, but the persistence of that dominance is unclear to me,” Cabana said.

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