Lag in the SOFR-Linked Non-Linear Derivatives Market: Three Barriers to Transition
This article is derived from a Risk.net webinar sponsored by Numerix, where an industry panel discussed how liquidity has developed in SOFR-linked non-linear products.
This paper is derived from a Risk.net webinar sponsored by Numerix, where an industry panel discussed how liquidity has developed in SOFR-linked non-linear products. They discussed what structural adaptations have taken place in the transition and the impact on behaviors of the instruments; the challenges of valuing SOFR-linked products; as well as the potential for a relaxation of the restrictions in the use of the SOFR term in derivatives. Three themes have emerged from the discussion.
- New Overnight Behavior: Traders and portfolio managers are still familiarizing themselves with the new overnight behavior of SOFR, which is quite different from that of LIBOR. The structural adaptations that have taken place to hitch products to this backward-looking rate have given rise to the daily compounding nature, recycling and reuse. This is quite different from the behavior banks were used to with LIBOR, which makes it quite difficult for the SOFR-linked non-linear market to pick up.
- SOFR Swaps Market Data: One of the main barriers to the transition to SOFR in the non-linear derivatives markets is the availability of market data. A key issue is that the liquidity of the trading space has not yet reached the vendor side. So, SOFR swaptions market data is not yet generally available from major vendors. When it is available, liquidity is a concern.
- Restrictions to Term SOFR: The restrictions on the use of term SOFR are another reason traders and portfolio managers are hesitating to start using SOFR-linked products until market liquidity is better. Currently, there is a strong bar against term SOFR in the derivatives market. Term SOFR swaps can only be traded to hedge a cash loan. No speculation or hedging of just interest rate risk for asset managers can be done outright, and term SOFR cannot be traded in an interdealer broker market.
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