Dealers Shift Default Rate for USD Linear Swaps to SOFR

Market observers reported a sharp increase in SOFR swaps transacted, a trend said to be “clear and pronounced”.

Swaps desks on Monday (26 July) switched from LIBOR to SOFR when entering into most interdealer trades, effectively changing how they hedge interest-rate risk.

The shift was recommended by the CFTC’s (Commodity Futures Trading Commission) Market Risk Advisory Committee (MRAC) and endorsed by the ARRC (Alternative Reference Rates Committee) last month, as part of a four-phase ‘SOFR First‘ initiative.

Under the plan, interdealer brokers were to replace LIBOR with SOFR as the default rate for USD linear swaps (e.g. outright swaps, swap spreads, curve trades) on 26 July 2021, and keep interdealer LIBOR screens available only until 22 October 2021.

The move is aimed at creating more volume in SOFR derivatives, and pave the way for the ARRC to formally recommend the CME’s forward-looking SOFR term rates. A similar move was taken in the UK last year to help get swaps desks in London to abandon LIBOR.

On Monday, the ARRC released a statement welcoming the convention switch from USD LIBOR to SOFR. It added that it expects its market indicators for a SOFR term rate to be met upon the convention change, allowing the ARRC to formally recommend the CME SOFR Term Rates “very shortly thereafter”.

“Today’s convention switch is off to a great start, with brokers and dealers strongly engaged in the work,” said Tom Wipf, ARRC Chairman and Vice Chairman of Institutional Securities at Morgan Stanley.

“In our initial outreach to inter-dealer brokers today, the ARRC is hearing that the forward looking projection for SOFR activity appears to be positive. This should provide strong momentum for the ARRC to recommend the CME SOFR Term Rates.”

“If signs continue to trend as they currently are progressing, we expect to formally recommend the CME SOFR Term Rates very soon. Remember: we’re just five months away from no new LIBOR, so I urge everyone to take action immediately to transition to SOFR.”

On Monday, Clarus Financial Technology offered running commentary on swaps activity:

“I think I would summarise it as a ‘good effort’ and certainly one of the more successful days in the transition story.”

“Most importantly, we saw sustained SOFR activity throughout the trading day. There was trading across the whole curve in a number of different products. Spreadovers versus SOFR can be considered particularly successful with 28 different trades. There were ‘only’ 22 Spreadovers versus LIBOR. Well done US markets, this feels like a good starting point.”

On Tuesday, Clarus said “the trend is clear and pronounced, a sharp increase in SOFR Swaps transacted.”

The next phase of ‘SOFR First’ is to replace LIBOR with SOFR as the default rate for cross currency swaps with legs involving CHF, GBP, JPY and USD LIBOR on 21 September 2021.

In the final two phases, the switch will occur for non-linear derivatives (e.g. swaptions, caps, floors) and exchange traded derivatives (e.g. futures) on dates as yet not confirmed.

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