‘Big bang’ sends basis swaps on roller-coaster ride

Secrecy at CME is contributing to volatility ahead of next week’s switch to SOFR discounting

The SOFR/federal funds basis market has seen some extraordinary moves ahead of the ‘big bang’ discounting switch at clearing houses later this month.

The basis between swaps linked to the effective federal funds rate and the secured overnight financing rate (SOFR) hit an all-time high of almost 8.5 basis points at the long-end on September 17 – suggesting a deluge of one-sided risk was about to hit the market. The gap narrowed almost 1bp the following day, after LCH revealed the pot of basis swaps set to be auctioned on October 16 as part of the discounting switch may be more digestible than some feared.

The feeling of calm was short-lived. Within 10 days, the basis widened to a new record of nearly 9bp, as traders began fretting about the size of positions that will be offloaded by clients of CME.

The Chicago-based clearing house is keeping that information tightly under wraps ahead of its auction on October 19.

The ‘big bang’ will see LCH and CME switch to using SOFR to value and pay interest on cash collateral for $134 billion of cleared US dollar swaps. The CCPs will distribute basis swaps to restore users’ discount risk exposures following the change. The auctions will allow users to offload any unwanted basis swaps they receive.

The deadlines for opting out of those swaps have now closed at both CCPs. That means the size of the auctions is fixed, save for any last-minute repositioning or a shock move in rates markets.

At LCH, the volume of swaps being auctioned is around $26 billion notional. The size of CME’s auction is a mystery. And it will remain so to all but the participating dealers, who will be told the size – but not the direction – of the portfolio just prior to the auction.  

In the absence of full disclosure, some traders have treated LCH’s numbers as a proxy for the whole market. After all, the London-based CCP is home to $123 trillion of US dollar swaps notional – around 90% of the total. CME houses just $7.6 trillion of US dollar interest rate swaps.

But it might be a mistake to ignore the smaller CCP in this instance. With a business skewed towards end-user activity, analysts say CME may need to offload an outsize amount of unwanted basis swaps at the longer, less liquid end of the curve.

Analysts at JP Morgan reckon the CME is home to more than 85% of discount risk from insurance companies

These longer-dated tenors have seen the largest basis moves in recent months. At issue is the dominance of insurers and pension funds in the 30-year swap market. These users are all positioned the same way and are sitting on hefty discount risk exposure. Most of them are expected to dump their swaps at the auctions.

LCH calmed those fears when it revealed its illiquid 30-year bucket contained just $500 million notional as of September 17. This has since fallen to $382 million, according to an October 1 update.

CME’s contribution could be higher, some say. Analysts at JP Morgan reckon the US CCP is home to more than 85% of discount risk from insurance companies.

That may explain why the 30-year SOFR/federal funds basis widened to 8.94bp by September 29 after narrowing in response to LCH’s initial disclosure. The twists and turns have continued. LCH’s October 1 announcement caused the basis to narrow again to 8.14bp.

The two-step process at CME, which sees unwanted swaps auctioned on a Monday – three days after the instruments are distributed – adds another wrinkle to an already complicated operation. Any last-minute volatility in the basis could leave users short-changed, or unable to offload their swaps at the auction.

That wouldn’t be a good look for SOFR, which is already struggling to find acceptance in some corners of the market. A trouble-free discounting switch could be crucial to ensuring an orderly transition away from US dollar Libor.