At last we left off on the story of the Secured Overnight Funding Rate (“SOFR”), SOFR just started trading (HERE). At that time, we discussed the very first rate setting, the rare wonder of seeing a new index created and what bankers need to do to prepare for the possibility of using a new index in their investment and loan process. Now, as of last week, there is a newly created futures market. In this article, we give a quick update on the index that is the presumptive heir to Libor and underscore some key concepts that are central to loan and deposit pricing in addition to asset-liability management.
As we discussed in detail in the past, SOFR is a measure of the cost of borrowing cash on a secured, overnight basis. Put another way, it is a measure of interest rate risk with most all credit risk removed. This concept is much different than Prime and Libor as both those indices contain an element of credit risk. For example, borrowers that accept a Comerica Prime or Libor rate are taking “A-“ long-term risk and “A-2” short-term risk. This means that Comerica likely has to pay a small premium in the market because of this credit risk thereby potentially increase their index rate. SOFR, since it is collateralized, has no such impact.
Lately, SOFR has been trading between 1.71% and 1.77%, with the last rate on Friday at a 1.73%. Each day, approximately $750B trade in the SOFR market. If you have not already done so, bankers should bookmark the Federal Reserve’s SOFR page (HERE) as the index’s importance is likely to grow.
The Futures Market
To be a reliable index, you need liquidity. If an index or instrument is illiquidity, for example, Bitcoin, there is a transaction and liquidity premium that gets built into the price. As such, similar to credit risk, the rate starts to reflect something other than which the rate was intended. If SOFR wasn’t trading as much as it was and you saw the rate was at 2%, you would not know how much of that rate compensated for interest rate risk and how much compensated for liquidity risk.
By contrast, one huge advantage of Libor, the Treasury and the swaps market, is that not only can you purchase the instruments now, on a “spot” basis, but you can also purchase one-month Libor or a five-year swap rate, for next month, or next year. This is extremely important for hedging and operational purposes and serves to make instruments like Libor, Treasuries, and swaps extremely useful.
Up until last week, you could purchase SOFR for immediate, or spot settlement but not for settlement into the future. As of last week, you could purchase SOFR for a future settlement date which is now the start of a futures market. This is the next major milestone to becoming a usable index.
Last week, overnight SOFR now has two types of contracts trading out into the future. One contract has a mid-month settlement date that resets quarterly which is similar to how Libor futures are traded while the other contract has a month-end settlement that resets monthly that is similar to how Fed Funds futures are traded.
As you can imagine, with just one week of trading, activity is light. As of the end of the week, the monthly contracts only went out to about seven months into the future, while the quarterly contracts went out about 13 months.
To give some context, the six-month SOFR rate is approximately 2.00%, which is similar to where the six-month Fed Funds contract trades which makes sense as the market is expecting another rate increase in June.
Banking Knowledge & The Key Limitation To SOFR
Now, here is something to get your head around that will make you a better banker - This futures market that started last week in SOFR is for overnight rates only.
That is, when we say that the six-month, monthly contract is trading at a 1.98%, that means that 30-days of overnight SOFR rates should average 1.98% in six months of time. The six-month futures contract is one-month of average overnight rates trading six months into the future. That is different than what is called a “term market” where you can purchase a six-month contract for SOFR.
For clarity, the term market is built on the overnight market, so you have to have one without the other. However, we bring this aspect up as when people doubt if SOFR can replace Libor, they mostly focus on the difficulty of building a term market AND a term futures market. Libor’s huge advantage, right now, is that your bank can purchase a 3-month Libor contract for settlement now, one month from now, six months from now or for 12 months or more into the future. Libor has an active overnight, futures, term, and term futures market for a variety of contracts out to one year.
Why This is Important for Asset Liability Management – Pricing and Partial Duration
This is confusing for sure but vitally important to understand these concepts if you are going to excel in banking. It is this term and term futures market that allows us, here at CenterState, to create a variety of loan and deposit structures. If a client knows that are getting a legal settlement of $1mm in three months and wants to purchase a 1-year CD ahead of time to lock the rate in now for some reason, pricing this isn’t an issue. We simply see where 1-year Libor is trading in three month’s time and apply our current deposit spread to the index.
Having a liquid term futures market can also allow us to lock in a fixed loan rate for 10-year’s time, one year from now. For that matter, using Libor out to a year and the swaps market from one to 30 years allows us to create or quote any deposit or loan structure imaginable.
In addition, by knowing the term structure of rates, we can see where the potential pricing problems and interest rate risk is on our balance sheet. A futures and term market allows us to get exact “key rate” or “partial” durations. A bank with a concentration in commercial loans that reset in five-years is not so concerned about what happens in the two or three-year area of the curve but exposed to what might happen on the reset day. Let’s say the bank has a big loan that resets in June of 2023. For asset-liability management purposes, the banker really wants to know the partial duration of June of 2023.
This is one reason why we convert every instrument on our balance sheet to a spread to Libor or swaps. Prime-based loans, bonds, non-interest bearing deposits, certificates of deposits and even fee income streams get converted to a spread to Libor (if less than one year in maturity) or swaps (if longer than one year in maturity). This allows us to understand pricing and risk on every instrument in real-time (since the market is in real-time).
It is a huge step for SOFR to develop a liquid futures market. Over time, more contracts will be created further out the interest curve. The next major milestone is to see if a term market develops for the product. If it does and can be sustained, then it is likely to replace Libor. However, this will likely take some time. Until then, Libor, swaps, and Treasuries give banks still the best market for pricing.
The creation of the SOFR index gives bankers an important window to seeing the birth of a new index to learn firsthand about the term structure of interest rates. Seeing a market develop in real-time gives bankers a better understanding of how a yield curve is created.
As more liquidity comes into the SOFR futures market, contracts will become more accurate and will further extend out into the future. A futures market, along with a term and term futures market allow bankers to understand the interest rate risk of any period of time. Having this knowledge is critical to pricing, product administration, and asset-liability management.
Submitted by Chris Nichols on May 14, 2018