More on fallback spreads

Risk free interest rates (RFR) like SOFR for USD are replacement rates for Libor. Unlike Libor, RFR do not include a credit spread component and so a spread adjustment is added to the RFR to account for the difference. This spread adjustment is the fallback spread to be used for legacy LIBOR linked contracts when LIBOR publication has been discontinued. There is likely to be different fallback spreads used for cash products and derivatives and ISDA has published their fallback adjustment for derivative markets as follows:

Compounded setting in arrears RFR rate + spread adjustment based on the median spot spread between the IBOR and the term-adjusted RFR calculated over a static lookback period of five years prior to the Index Cessation Event

The index cessation event is a public statement by the LIBOR regulator or administrator that publication has ceased or will cease and result in fallback spreads being fixed and applied as a spread adjustment to the RFR to create an “all-in” fallback rate.

If index cessation event happened today fixing the fallback spread for 3m USD, it would cover a period from December 2015- December 2020 and would be about 26bps (see chart). In contrast, if a cessation were announced in June 2023 then the spread would cover a period from June 2018 to June 2023 and is likely to be lower than 26bps because higher levels of the fallback spread in 2016 drop out of the dataset that the 5Y median references.  

ISDA 3m USD Fallback spread Jun 2015-June 2020.  5Y median = 26bps 

During November 2020, the market was expecting a cessation announcement sometime during 2021 and was pricing fallback spread expectations c. 26bps, to be applied as part of an all-in rate shortly after December 2021. On 30th November, IBA effectively announced an extension of the discontinuation timeline for US Libor to mid-2023. This caused the market to price expectations that fallback spreads would apply to Eurodollar futures settling post June 2023 based on a spread calculated from a 2021 cessation event.  This caused pre-June 2023 contracts to rally relative to contracts settling post-June 2023 since they would now settle to actual Libor perceived to be lower than the “all-in” rate to be applied post-June 2023. The 4th December ISDA announcement effectively ratified this pricing adjustment.

Eurodollar (ED) futures react to Libor transition announcements

For an explainer on Libor transition, see preceding post.

On Monday, 30th November, IBA announced the start of a consultation that involves an extension of the discontinuation timeline for key tenors in US Libor to mid-. This announcement caused ED futures settling pre-June 2023 to move higher since expectations are that these contracts will now reference actual Libor, expected to be lower than fallback Libor that would affect contracts settling post-June 2023. 

EDM2 reacts to IBA announcement on 30th November. Chart by Refinitiv

On Friday 4th December, ISDA stated, “an announcement early next year for all US dollar LIBOR tenors would fix the spread for all tenors. And in that instance, the spread would be applied – that is to say, contracts would fall back to the fall-back rate after June 2023.”

ED futures continued their post 30th November trend more aggressively by re-pricing the post-June 2023 strip (referencing the fall-back rate) about 10bps higher (futures price fall 10 ticks) than those settling pre-June 2023 (which would continue to reference USD 3m LIBOR).  ED M3U3 widened by about 10 ticks from 30th November. This was effectively a 10 standard deviation event on a one-year trading range of 4.5 ticks.  

ED M3U3 spread widens 10 ticks on elevated volume. Chart by Refinitiv

Benchmark reform and Libor transition explainer

Benchmark reform is the impending  transition from one type of interest rate used to reference some $350 trillion of corporate loans, debt and derivative product from the end of 2021-mid 2023 to other alternative rates. It is likely to affect interest payments and product valuation.

The most popular benchmark reference interest rate is the London Interbank Offered Rate (LIBOR. It is supposed to be representative of wholesale, unsecured transactions in a variety of hard currencies (presently USD, GBP, EUR, GHF and JPY) for several maturities between overnight and 12 months. Every business day, a benchmark administrator collates submissions from contributor banks based on their actual transactions or by using the contributor’s expert judgment when few or no transactions have taken place, and publishes LIBOR fixings. Global lending markets reference these fixings for customer and client borrowings, usually adding a credit spread to reflect the relative creditworthiness between borrower and lender. These fixings are also an integral component for huge amounts of derivative and capital markets product. 

The early 2000’s saw advances in credit risk management practices that made bankers increasingly reluctant to lend wholesale funds on an unsecured basis on anything but an overnight term – the premise being that fewer bad things might happen to monies lent overnight compared to a term loan. Consequently, most of the approximately $500m daily LIBOR transactions are overnight only meaning that term LIBOR fixings are largely subjective, not being based on any substantial amount of trade.  In the past, this has made term LIBOR susceptible to manipulation, resulting in fines for banks and prison sentences for traders. The early response was the Wheatley Review in 2012, initial reform of LIBOR, greater regulatory oversight and a recommendation by the Financial Stability Board in July 2014 to develop nearly Risk Free Rates (RFR) as alternatives to LIBOR. This is benchmark reform.

Working Groups on alternative reference rates in various jurisdictions have proposed different risk free rates to replace LIBOR; some using secured financing data sources whilst others reference unsecured money market data. They have varying publication times, different administrators and all are overnight rates only.

In the United States, the Secured Overnight Financing Rate (SOFR) is the preferred risk-free rate for USD markets. SOFR derives from secured financing transactions, otherwise known as repo. Over $1trillion of SOFR linked transactions transact each day. Repo markets have their own challenges though, demonstrated by recent ructions in US markets due to liquidity issues. Perversely, this can result in a replacement risk free benchmark rate that is potentially more volatile than the rate it is replacing.

Term LIBOR fixings give cash flow certainty. A borrower borrowing money today for 12 months will know exactly how much they will have to repay in a year’s time if the loan references a 12-month LIBOR rate fixed today.  This is an in advance borrowing. Replace this with an alternative rate referencing an overnight rate instead and the borrower will have to wait until the loan matures before they know exactly how much is due. This is an in arrears borrowing. The lack of a term structure for many proposed replacement rates creates uncertainty of future cash flows.

Additionally, most borrowers, lenders and derivative markets participants will have legal documentation detailing their obligations.  Within these documents is fallback language that sets out the legal steps to be taken in case LIBOR becomes temporarily unavailable. These contracts will need amending for a permanent discontinuation, involving a trigger protocol, details of the replacement rate and a replacement spread applied to the new rate to make it economically equivalent to the old rate, replicating existing credit spreads with no financial advantage or disadvantage to borrower, lender or derivative counterparty.

Benchmark reform in various jurisdictions is currently at different stages of transition, and is moving at different speeds towards, in all likelihood, different outcomes. The results could potentially have an unpredictable and adverse impact on the valuation and obligations of financial instruments like loans, bonds and derivative product. Financial organisations will need to adapt to new or amended operational processes and changes to contractual documentation will require communication, education and treating customers and clients fairly.

July 24th, 2019: Euribor Z0H1 spread.

A strip of Euribor futures are derivatives on sequential forward starting inter-bank offered rates. As would be expected, each Euribor future is highly and consistently correlated with its adjacent contracts.  For example, a Z0 future (expiring in December 2020) might be ≈98% correlated with the H1 (March 2021) contract.  

This stable relationship between adjacent contracts make spread trading in the form of calendar spreads (future1 -future2) or butterfly’s (future1- 2x future2-future3) very popular as a low volatility trading strategy albeit often requiring high leverage in order to generate enough return.

It is difficult to imagine how Euribor futures could ever become negatively correlated to each other but as is often with risk, reality can be stranger than theory. This happened once in my trading lifetime in 1999 due to a phenomenon subsequently called the millennium fly. This was when the Z0 (December 2000) futures sold off sharply (implied forward rates increased since stir futures are quoted on a 100-r basis) whilst the adjacent U9 (Sept 1999) and H1 (March 2001) contracts continued a upward trend (implied forward rates decreased) in line with other interest rate related product. This effect was later attributed to a US bank allegedly being refused access to funding markets in the new millennium for being deemed to be non-Y2K compliant.  

This effect of Euribor futures becoming negatively correlated has happened again for the first time in 20 years (to my knowledge). During the 2019, up until 24th July, the Z0H1 (December 2020-March 2021) spread traded in a range of 0.02 to 0.07 with an average daily spread volume of ≈4000.

During normal trading hours on 24th July, the Z0H1 spread had traded between 0.02 and 0.03, but from 17:25 hrs to 17:37 hrs on the same day, blew out to 0.14 and then traded back down to 0.03 by 18:37pm on a volume of over 90,000 contracts. This was driven by aggressive buying of ≈60,000 Z0 contracts from a price of 100.565 to 100.640 whilst the H0 sold off from 100.535 to 100.510 on volume of ≈28,000 during the same time period (17:25 hrs to 17:37 hrs).

The charts below graphically display the moves in the both the spread and the individual futures contracts, highlighting the temporary enforced negative correlation between Z0 and H1. Charts by Reuters Eikon.

Z0H1 Spread: 24/07/19 Tick data, Price and volume
Z0 (top) and H1 (middle) futures:
24/07/19 1 min data, Price and volume (Z0 bottom)

This was probably a very expensive 12 minutes from the perspective of proprietary traders and the instigator of the trade. The adverse mark-to-market on leveraged short Z0H1 positions might have led to proprietary traders buying back short spreads to reduce inventory but thereby exacerbating the move. Whoever or whatever was behind the trade would have ultimately lost money since the spread and the individual component futures contracts subsequently normalised back to levels seen earlier in the day. Given that none of the trades violated the Exchange’s tolerances and circuit breakers, all trades stood, and none were cancelled.

The move defies logic. The next day (25th) was an ECB policy meeting day but rates were unchanged and there was no market moving news regarding QE policy. The move was measured in minutes, not milli-seconds, perhaps ruling out a fat finger or flash crash. Someone might have a very specific idea regarding European rates in Q120, but it was awful trade execution to achieve it. Market manipulation? Isn’t the idea the make money from that. This trade would have lost the instigator money. Focus will probably fall on an algorithmic error, but the reality is that we will probably never know for sure.  Maybe it’s a sign of age but when things like this happen, I’m glad that I’m no longer in the game!  

The demise of stir futures?

Stir futures are, of course, futures on short term interest rates, primarily IBORs (interbank offered rates). The Eurodollar and Short Sterling are based on LIBOR (London Interbank Offered Rate) and the Euribor is named after its underlying reference rate – EURIBOR (Euro Interbank Offered Rate).

Because of the LIBOR/EUROBOR fixing scandals, plus operational aspects like the lack of volume and submission and fixing methodology, the FSB (Financial Stability Board) published a report in 2014 on “Reforming Major Interest Rate Benchmarks” which provided the basis for the FCA’s (Financial Conduct Authority) decision to sustain LIBOR until the end of 2021. After that, panel banks will no longer be required to submit LIBOR rates, which likely lead to the demise of LIBOR as a reference rate and remove the demand for derivatives based upon it.

As an alternative, the following have been adopted as reference rates

USD: Secured Overnight Financing Rate (SOFR)

EUR: Euro Short-term Rate (ESTER)

JPY: Tokyo Overnight Average Rate (TONAR)

GBP: Sterling Overnight Index Average (SONIA)

CHF: Swiss Average Rate Overnight (SARON)

SOFR is a fully transaction-based reference rate, derived from a composition of repo rates – General Tri-Party (Bank of New York Mellon), DTCC cleared General Collateral and Bilateral FICC cleared. SOFR daily trading volume is around $800 B which is about 1500 times the daily LIBOR transaction volume.

In the US, SOFR futures were introduced by CME in May 2018 and because they are based on a secured financing rate (in contrast to LIBOR being based on unsecured financing), the SOFR futures trade at a higher price (lower rate) that Eurodollar futures.

Source: Bloomberg

Volumes are increasing

Source: Bloomberg

And a developing market in inter contract spreads

Source: Bloomberg

Based on a presentation by Numerix

Causation between 3M Euribor fixings and Euribor futures rates

Are changes in Euribor fixings correlated with movements in the Euribor implied forward rates?

Intuitively, we might think so but empirical evidence suggests otherwise. Given a data set from January 1999 to May 2017, there were 2740 days when a change in the Euribor fixing was replicated with a similar movement in the implied forward rates of the white pack and 1964 days when they were not. This results in a low correlation of just 17.6%. Breaking the data into smaller 5-6 year buckets does not demonstrate causality between the direction of Euribor fixings and movements in the Euribor futures implied forward curve.

causal

Policy rate tightening

With all this talk about Fed tightening in the autumn with UK rises to follow in early 2016, it might be useful to remind ourselves of the strong inverse relationship between stir futures and policy rates. Of course, stir futures are LIBOR linked derivatives but LIBOR is very closely correlated with policy rates making stir futures ideal for the systematic trading of policy rate changes.

The first chart shows the front month continuous short sterling contact (orange RHS) and the BOE Base Rate (purple LHS) over the last 20 years.

UK Source: Reuters Eikon

The inverse relationship is clear and most importantly shows that when policy rates start changing, stir futures start trending.

Same with the US. (Eurodollar front month continuous in purple (LHS) and Fed Funds Effective Rate in orange (RHS)

US

Source: Reuters Eikon

It can also be observed that the US often acts preemptively to the UK. When America sneezes, the UK catches a cold.

 

The year -end turn effect

The year-end effect in STIR futures is a legacy from the 1980’s. There are often high borrowing requirements at year end as Banks look to bolster their cash reserves at the end of a fiscal year or quarterly period. This requirement and the fact that the days straddling the end of one year and the beginning of the next fall in the holiday season and create an overnight borrowing period that can be two or four days in duration due to bank holidays.

In December 2013, the year end turn effect would have been muted since money could have been borrowed on Tuesday 31st December 2013 and returned on Thursday 2nd January 2014. This would have been just two days but if those days had straddled a weekend, it could have been four. It can have an effect on STIR futures because year end is included in the forward period covered by the December contract.

2

 

If the forward deposit period rate was 1%, then the futures implied rate should be

3

 

However, if rates jumped to 1.5% over the turn, the futures implied rate would be:

4

 

Clearly this is insignificant when the turn premium is 0.50% and the turn period two days so it is off most STIR trader’s radar apart from the most exceptional periods like run up to December 1999 when the markets were spooked by the millennium bug (Y2K) fears. This was most clearly observed in the Sterling Dec butterfly.

5

 LIFFE Short Sterling U9Z9H0 butterfly Apr 98 to Sep 99 (price differential)

Worries that that non Y2K compliant Banks would be refused year end funding caused the Z99 future to fall sharply relative to the surrounding U99 and H0 contracts, causing the usually staid butterfly spread to blow out by around 80 ticks (bps). This also happened to Eurodollar and Euribor and was probably a once in a generation occurrence but watch out for potential repeats driven by, for instance, rumours of Banks failing regulatory requirements.

Looking at the latest set of Euribor Dec butterfly’s in the chart below, there are no discernible Dec premium reflecting year-end turn premiums, mainly because Central Banks are very adept at financing these days and post the financial crisis, Banks have relatively easy access to central bank funding

6

 LIFFE Euribor Butterfly’s (Dec fly’s are coloured and surrounding fly’s are greyed for contrast)

However, despite the fact that the year-end turn effect seems to be diluted by the relatively small turn premiums in Dec fly’s these days, there is another aspect to consider relating to year end liquidity:

Stricter liquidity regulation caused a significant reduction in the liquidity available in the overnight market during December 2013, which fuelled sharp upward pressure on the overnight cost of cash. Having started December at 11.2bp, EONIA moved up to 20.6bp on 17 December, then declined a little to 17.1bp on 24 December before spiking in the last week of the year to 44bp in an illiquid market.

This effect can be observed on changes in the Euribor strip.

7

 LIFFE Euribor Strips November to December 2013

The strip yield increases, almost in parallel as condition tighten in the EONIA market during December and the causal link is observable between 3M OIS and Euribor Z3.

8

Indeed, there seems to be a general pattern of tighter overnight rates in the euro zone and a quick study reveals that in seven out of the last ten years (2004 to 2013), Euribor futures closed lower (rates higher ) at the end of December compared to where they started December.

Interest rate change probabilities

STIR futures are not the ideal instrument for determining policy rate change probabilities since they are LIBOR or EURIBOR linked derivatives. These 3 month interbank fixings are not the same as policy rates and there is often substantial disparity between them. However, STIR futures are often used to speculate on or hedge against changes in official interest rates due to their liquidity and transparency since all short rate products will generally reflect changes in policy rates.

There has recently been much in the UK press about the Bank of England’s (BOE) forward guidance policy.  Market expectations of base rate increases have been pulled forward in response to improving economic conditions, particularly the rapid decline in unemployment.

It is possible to determine the probabilities of base rate changes within a particular time frame by the use of a specific instrument called a Meeting Dated Overnight Index Swap. 

IR prob 3

 The table below shows the BOE MPC meeting dates for the next year and corresponding meeting dated OIS rates.

table2

 

Example

The rate for the MPC meeting on 8th May 2014 is 0.499%. This rate is the market rate of a one month forward starting OIS, starting on 8th May and maturing on 5th June. 0.499% is the fixed OIS rate quoted against receiving compounded daily SONIA for one month between these dates. If base rates were increased on or before 8th May from the present level of 0.5% to 0.75%, then the OIS fixed payer would be in the money, paying just 0.499% for a month against receiving SONIA which would have increased to around 0.75%.

The probability of a 0.25% (25bps) increase in the base rate on or before 8th May would be calculated as:

IR prob

This is basically saying that the market puts 0% probability of a 25bps base rate increase occurring by May 2014. This probability has increased to 80% by February 2015 reflecting the current market consensus for the first 25bps increase in base rates to occur early in Q2 2015.

The graph below illustrates the term structures of MPC dated OIS, market consensus base rate forecast and the LIFFE Short Sterling STIR futures strip (expressed as implied forward rates).

graph2

Term structures of UK BOE MPC dated OIS, market consensus UK BOE base rate forecasts and the LIFFE Short Sterling STIR futures strip (expressed as implied forward rates): Late January 2014

The Short Sterling futures should not be interpreted as being more aggressive in terms of interest rate expectations, the difference between the rates just reflecting their  types: forward SONIA OIS as compared to  forward 3M LIBOR. However, the gradient of the Short Sterling term structure suggests uniformity with the OIS expectations, suggesting equilibrium between products in terms of future interest rate expectations.

From a traders perspective, if rates were thought to increase sooner and faster than expected, then the curve would steepen (buy Short Sterling calendar spreads) and if rates were thought to be on hold and increase at a much slower rate than forecast, then the curve would flatten (sell Short Sterling calendar spreads). Watch this space…