SOFR: Farewell to LIBOR
CME: SOFR ( 
SR31!)
On June 30th, SEC Chairman Gary Gensler posted a 3-minute short video on Twitter. In this educational piece titled RIP LIBOR, he explains what the London Interbank Offered Rate (LIBOR) is, and why its passing away is actually a good thing for consumers.
As CFTC Chairman in 2009-2014 and SEC Chairman since 2021, Mr. Gensler oversaw the investigation of the 2012 LIBOR scandal and its replacement by the Secured Overnight Financing Rate (SOFR) in 2021 as the benchmark interest rate for US dollar.
Eurodollar and LIBOR
Offshore Dollar, the US currency deposited in banks outside of the United States, is commonly known as Eurodollar. Traditionally, offshore dollars were traded mainly among European banks. The name sticks to these days and applies to funds in non-European banks as well.
A key advantage of trading Eurodollar is the fact that it is subject to fewer regulations by the Fed, being outside of the US jurisdiction. London is the largest trading hub for Eurodollar.
The London Interbank Offered Rate came into being in the 1970s as a reference interest rate in the Eurodollar markets. By 1986, the British Bankers' Association (BBA) began publishing the US Dollar LIBOR daily. The BBA Libor was calculated based on interest rates reported by 17 member banks who together represented the bulk of Eurodollar transactions. Libor has been widely used as a reference rate for many financial instruments, including:
• Forward rate agreements
• Interest rate futures, e.g., CME Eurodollar futures
• Interest rate swaps and swaptions
• Interest rate options, Interest rate cap and floor
• Floating rate notes and Floating rate certificates of deposit
• Syndicated loans
• Variable rate mortgages and Term loans
• Range accrual notes and Step-up callable notes
• Target redemption notes and Hybrid perpetual notes
• Collateralized mortgage obligations and Collateralized debt obligations
How important was Libor? It is a reference rate in the documentation by private trade association International Swaps and Derivatives Association (ISDA), which sets global market standard for OTC derivative transactions.
In 2008, 60% of prime adjustable-rate mortgages and nearly all subprime mortgages were indexed to the USD Libor in the US. Furthermore, American cities borrowed 75% of their money through financial products that were linked to the Libor.
Libor has been the indispensable global benchmark for pricing everything from credit card debt to mortgages, auto loans, corporate loans, and complex derivatives.
CME Eurodollar Futures
In 1981, the Chicago Mercantile Exchange launched Eurodollar futures, the first ever cash-settled futures contract. It quickly became the most liquid contract by CME. At its peak, over 1,500 traders and clerks worked at the Eurodollar pit on CME trading floor.
Not to be confused with the Euro currency, Eurodollar futures contracts are derivatives on the interest rate paid on a notional or "face value" of $1,000,000 time deposit at a bank outside of the United. It uses the 3-month USD Libor rate as its settlement index. The late Fred D. Arditti, CME economist, is credited as the brain behind Eurodollar futures.
Eurodollar futures are priced as a Money Market instrument. The CME IMM index is used to convert a coupon-bearing instrument such as bank deposit, into a discounted instrument that does not make regular interest payments.
For instance, a futures price of 95.00 implies an interest rate of 100.00 - 95.00, or 5%. The settlement price of a Eurodollar futures contract is defined to be 100.00 minus the official BBA fixing of 3-month Libor on the day the contract is settled.
The 2012 LIBOR Scandal
The LIBOR Scandal was a highly publicized scheme in which bankers at major financial institutions colluded with each other to manipulate the Libor rate. As the scandal came to light in 2012, investigators found that the banks had been submitting false information about their borrowing costs to manipulate the Libor rate. This allowed the banks to profit from trades based on the artificially low or high rates.
A dozen big banks were implicated in the scandal. It led to lawsuits and regulatory actions. After the rate-fixing scandal, LIBOR's validity as a credible benchmark was over. As a result, regulators decided that Libor would be phased out and replaced.
If you want to learn more about the LIBOR scandal, feel free to check out the 2017 bestseller by David Enrich: “The Spider Network: The Wild Story of a Math Genius, a Gang of Backstabbing Bankers, and One of the Greatest Scams in Financial History”.
What is the SOFR
In 2017, the Federal Reserve assembled the Alternative Reference Rate Committee to select a Libor replacement. The committee chose the Secured Overnight Financing Rate as the new benchmark for dollar-denominated contracts.
The daily SOFR is based on transactions in the Treasury repurchase market, where firms offer overnight or short-term loans to banks collateralized by their bond assets ,similar to pawn shops.
Unlike LIBOR, there’s extensive trading in the Treasury repo market, estimated at $4.8 trillion in June 2023. This theoretically makes it a more accurate indicator of borrowing costs. Moreover, SOFR is based on data from observable transactions rather than on estimated borrowing rates, as was the case with LIBOR.
The Federal Reserve Bank of New York began publishing the SOFR in April 2018. By 2021, SOFR has replaced most of the LIBOR-linked contracts. The LIBOR committee officially folded up on June 30, 2023. Chairman Gensler apparently chose this day to post his RIP LIBOR video to mark the end of an era.
The difference between Fed Funds Rate and SOFR
Fed Funds Rate is set by the Fed’s FOMC meeting, and SOFR is published by the NY Fed. However, they are very different.
• Fed Funds Rate is considered a risk-free interest rate, and only member banks have access to this ultra-low rate through the Fed’s discount window.
• SOFR is a commercial interest rate where banks charge each other. The NY Fed publishes the rate based on transactions in the US Treasury repurchase market.
SOFR is similar to LIBOR because they are both commercial interest rate benchmarks. On the other hand, Fed Funds Rate is a policy rate set by the US central bank.
CME SOFR Futures and Options
CME Group launched the 3-month SOFR futures and options contracts in May 2018. The contracts were based on the SOFR Index, published daily by the New York Fed.
SOFR futures contracts are notional at $2,500 x contract-grade International Monetary Market (IMM) Index, where the IMM Index = 100 minus SOFR. At a 5.215 IMM, for example, each contract has a notional value of $13,037.50. CME requires a $550 margin per contract. An interest rate move by a minimum tick of 0.25 basis point would result in a gain or loss of $6.25.
At the beginning, SOFR contracts traded side-by-side with the Eurodollar contracts. By 2021, Eurodollar liquidity has transitioned to SOFR contracts. By April 2023, All Eurodollar contracts were delisted, and the transition was completed.
For all intended purposes, you could think of the SOFR futures as the same as the legacy Eurodollar contracts, with the only notable exception being the settlement index switched from LIBOR to SOFR.
On June 30th, the daily trading volume and Open Interest of SOFR contracts were 4,443,245 and 9,310,433 contracts, respectively. On the same date, CME Group total volume and OI were 23,769,103 and 104,221,083, respectively.
On the latest trade day, SOFR accounts for 18.7% of CME Group’s trade volume and 8.9% of its total open interest. Indeed, SOFR has successfully replaced Eurodollar as new No. 1 contract at CME and is arguably the most liquid derivatives contract in the world.
Where We Are at the SOFR Market
On June 30th, the JUN SOFR contract (SR3M3) expired and settled at 94.785. This translates to the JUN SOFR rate of 5.215 (100-94.785).
SEP 2023 (SR3U3) is now the new lead contract. It settled at 94.595 and implied a forward SOFR rate at 5.405 (100-94.595). This shows that the futures market expects a rate increase in the next Fed meeting.
Like Eurodollar futures, rising futures price will confer to declining SOFR rate, as rate is equal to 100 minus futures price. Similarly, a decline in futures price equates to a rising SOFR rate.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/
SR31!)On June 30th, SEC Chairman Gary Gensler posted a 3-minute short video on Twitter. In this educational piece titled RIP LIBOR, he explains what the London Interbank Offered Rate (LIBOR) is, and why its passing away is actually a good thing for consumers.
As CFTC Chairman in 2009-2014 and SEC Chairman since 2021, Mr. Gensler oversaw the investigation of the 2012 LIBOR scandal and its replacement by the Secured Overnight Financing Rate (SOFR) in 2021 as the benchmark interest rate for US dollar.
Eurodollar and LIBOR
Offshore Dollar, the US currency deposited in banks outside of the United States, is commonly known as Eurodollar. Traditionally, offshore dollars were traded mainly among European banks. The name sticks to these days and applies to funds in non-European banks as well.
A key advantage of trading Eurodollar is the fact that it is subject to fewer regulations by the Fed, being outside of the US jurisdiction. London is the largest trading hub for Eurodollar.
The London Interbank Offered Rate came into being in the 1970s as a reference interest rate in the Eurodollar markets. By 1986, the British Bankers' Association (BBA) began publishing the US Dollar LIBOR daily. The BBA Libor was calculated based on interest rates reported by 17 member banks who together represented the bulk of Eurodollar transactions. Libor has been widely used as a reference rate for many financial instruments, including:
• Forward rate agreements
• Interest rate futures, e.g., CME Eurodollar futures
• Interest rate swaps and swaptions
• Interest rate options, Interest rate cap and floor
• Floating rate notes and Floating rate certificates of deposit
• Syndicated loans
• Variable rate mortgages and Term loans
• Range accrual notes and Step-up callable notes
• Target redemption notes and Hybrid perpetual notes
• Collateralized mortgage obligations and Collateralized debt obligations
How important was Libor? It is a reference rate in the documentation by private trade association International Swaps and Derivatives Association (ISDA), which sets global market standard for OTC derivative transactions.
In 2008, 60% of prime adjustable-rate mortgages and nearly all subprime mortgages were indexed to the USD Libor in the US. Furthermore, American cities borrowed 75% of their money through financial products that were linked to the Libor.
Libor has been the indispensable global benchmark for pricing everything from credit card debt to mortgages, auto loans, corporate loans, and complex derivatives.
CME Eurodollar Futures
In 1981, the Chicago Mercantile Exchange launched Eurodollar futures, the first ever cash-settled futures contract. It quickly became the most liquid contract by CME. At its peak, over 1,500 traders and clerks worked at the Eurodollar pit on CME trading floor.
Not to be confused with the Euro currency, Eurodollar futures contracts are derivatives on the interest rate paid on a notional or "face value" of $1,000,000 time deposit at a bank outside of the United. It uses the 3-month USD Libor rate as its settlement index. The late Fred D. Arditti, CME economist, is credited as the brain behind Eurodollar futures.
Eurodollar futures are priced as a Money Market instrument. The CME IMM index is used to convert a coupon-bearing instrument such as bank deposit, into a discounted instrument that does not make regular interest payments.
For instance, a futures price of 95.00 implies an interest rate of 100.00 - 95.00, or 5%. The settlement price of a Eurodollar futures contract is defined to be 100.00 minus the official BBA fixing of 3-month Libor on the day the contract is settled.
The 2012 LIBOR Scandal
The LIBOR Scandal was a highly publicized scheme in which bankers at major financial institutions colluded with each other to manipulate the Libor rate. As the scandal came to light in 2012, investigators found that the banks had been submitting false information about their borrowing costs to manipulate the Libor rate. This allowed the banks to profit from trades based on the artificially low or high rates.
A dozen big banks were implicated in the scandal. It led to lawsuits and regulatory actions. After the rate-fixing scandal, LIBOR's validity as a credible benchmark was over. As a result, regulators decided that Libor would be phased out and replaced.
If you want to learn more about the LIBOR scandal, feel free to check out the 2017 bestseller by David Enrich: “The Spider Network: The Wild Story of a Math Genius, a Gang of Backstabbing Bankers, and One of the Greatest Scams in Financial History”.
What is the SOFR
In 2017, the Federal Reserve assembled the Alternative Reference Rate Committee to select a Libor replacement. The committee chose the Secured Overnight Financing Rate as the new benchmark for dollar-denominated contracts.
The daily SOFR is based on transactions in the Treasury repurchase market, where firms offer overnight or short-term loans to banks collateralized by their bond assets ,similar to pawn shops.
Unlike LIBOR, there’s extensive trading in the Treasury repo market, estimated at $4.8 trillion in June 2023. This theoretically makes it a more accurate indicator of borrowing costs. Moreover, SOFR is based on data from observable transactions rather than on estimated borrowing rates, as was the case with LIBOR.
The Federal Reserve Bank of New York began publishing the SOFR in April 2018. By 2021, SOFR has replaced most of the LIBOR-linked contracts. The LIBOR committee officially folded up on June 30, 2023. Chairman Gensler apparently chose this day to post his RIP LIBOR video to mark the end of an era.
The difference between Fed Funds Rate and SOFR
Fed Funds Rate is set by the Fed’s FOMC meeting, and SOFR is published by the NY Fed. However, they are very different.
• Fed Funds Rate is considered a risk-free interest rate, and only member banks have access to this ultra-low rate through the Fed’s discount window.
• SOFR is a commercial interest rate where banks charge each other. The NY Fed publishes the rate based on transactions in the US Treasury repurchase market.
SOFR is similar to LIBOR because they are both commercial interest rate benchmarks. On the other hand, Fed Funds Rate is a policy rate set by the US central bank.
CME SOFR Futures and Options
CME Group launched the 3-month SOFR futures and options contracts in May 2018. The contracts were based on the SOFR Index, published daily by the New York Fed.
SOFR futures contracts are notional at $2,500 x contract-grade International Monetary Market (IMM) Index, where the IMM Index = 100 minus SOFR. At a 5.215 IMM, for example, each contract has a notional value of $13,037.50. CME requires a $550 margin per contract. An interest rate move by a minimum tick of 0.25 basis point would result in a gain or loss of $6.25.
At the beginning, SOFR contracts traded side-by-side with the Eurodollar contracts. By 2021, Eurodollar liquidity has transitioned to SOFR contracts. By April 2023, All Eurodollar contracts were delisted, and the transition was completed.
For all intended purposes, you could think of the SOFR futures as the same as the legacy Eurodollar contracts, with the only notable exception being the settlement index switched from LIBOR to SOFR.
On June 30th, the daily trading volume and Open Interest of SOFR contracts were 4,443,245 and 9,310,433 contracts, respectively. On the same date, CME Group total volume and OI were 23,769,103 and 104,221,083, respectively.
On the latest trade day, SOFR accounts for 18.7% of CME Group’s trade volume and 8.9% of its total open interest. Indeed, SOFR has successfully replaced Eurodollar as new No. 1 contract at CME and is arguably the most liquid derivatives contract in the world.
Where We Are at the SOFR Market
On June 30th, the JUN SOFR contract (SR3M3) expired and settled at 94.785. This translates to the JUN SOFR rate of 5.215 (100-94.785).
SEP 2023 (SR3U3) is now the new lead contract. It settled at 94.595 and implied a forward SOFR rate at 5.405 (100-94.595). This shows that the futures market expects a rate increase in the next Fed meeting.
Like Eurodollar futures, rising futures price will confer to declining SOFR rate, as rate is equal to 100 minus futures price. Similarly, a decline in futures price equates to a rising SOFR rate.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs tradingview.com/cme/
Jim W. Huang, CFA
jimwenhuang@gmail.com
jimwenhuang@gmail.com
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