JANUARY 2021 – RFR Alts: ICE Bank Yield Index & Bloomberg BSBY vs FIG-Proposed iVol-based Risk Add-On (part 2)
- Premise: Because Bank-Dealer Risk is a function of Realized Volatility (FFIEC-reported VaR), a Risk Add-On should target Anticipated Volatility (Option Implied Volatility).
- Bank Stress = Volatility
- The ARRC and Fed have abandoned finding an additional rate with credit sensitivity or finding an additive risk factor to append to new risk-free rates (RFRs).
- While many have proposed alternatives to add RFR risk sensitivity (CDX, IBYI, AXI, etc.), none are functionally tenable.
- So, seeking to alter the new RFRs to reflect stress in the system is not really about ‘credit’ per se. The RFR add-on is really about capturing events that cause bank stress—increases in bank VaR levels, elevated market volatility.
- Implied volatility is the cornerstone for building a “risk” add-on to new RFRs.
- The yield equivalent to implied volatility of options on Treasury Futures fulfills the main objectives to be the ‘risk add-on’ to new RFR benchmarks: near infinite liquidity, no data cost, accessible to virtually all institutions via exchange-traded futures market, can fit into existing LIBOR+x systems, works when bank stress is elevated.
- A year from now, anything basis-LIBOR is going to be a big problem. True, moving to SOFR without cost-of-funds tied to SOFR (not LIBOR+X as it is today) makes little sense. Every day that passes creates option value FOR the dealer community. Option value in terms of negotiating LIBOR->SOFR conversion spreads and credit adjustments. Option value in terms of liquidity for liquidating OTC LIBOR-Based derivatives and credit lines. While it’s rarely good to be first, it’s almost never good to be late when the ‘other side’ holds the cards.
- Yesterday, an entity placed a hedge (or bet) that the timeline for conversion is too compressed now. The trade they executed was buying $60bb EDZ’21 and selling EDH’22. This trade IS a “LIBOR screams higher post 12/31/21” position. Yesterday’s transaction that isolates LIBOR over the LIBOR-end-date is a friendly warning. Everything doesn’t have to be SOFR today or tomorrow. But, in my opinion, the vast majority of all LIBOR lines, loans, securities and bilateral transactions need to be gone by end of Q1/21.
A confluence of risks elevates red flags around and after the election. This report is a quick discussion about market-structure changes, VaR impact on credit lines, and the risk of a March-like pounding in the mortgage market.
- LIBOR, the benchmark for cost of funds for most non-bank fincos (aka ‘We borrow at LIBOR+X’), is at risk due to limited legit reference data (CP).
- Implied volatility increases may push bank VaR risk models that require reduction in credit lines and increase in margins for OTC derivatives.
- Reduction in lines to non-bank mortgage originators will be problematic for SOME. They will be forced to cover short TBAs, likely into a rallying market, and meet losses with cash—inasmuch as loan closing rates are still well behind.
- I. The Misunderstanding of Roll Spreads Implying Convergence/Carry/Drop
- II. Timing of Rolling Treasury Futures
- III. The Deliverable Basket, Conversion Factors, and Cheapest-to-Deliver
- IV. Calculating the Fair Value of the Roll Spread from the CTD’s
- Logic: If banks or funding markets become dislocated again before March of 2021, 3M LIBOR/3M T-BILL spread should blow out
- Trade: Buy MAR 2021 (EDH1) 99.625/99.500 put spread for 1.0 bp. Strike prices = 0.375 3M LIBOR Long Leg/0.50 3M LIBOR Short Leg
- Cost is $25 per spread
- Coverage: 11.5:1 max return at terminal value/expiration
- Using the 1-month Ameribor Futures, we can use the Fed’s favorite calculations (as applied to SOFR) to calculate our Term Ameribor rate.
- Step 1: Rendering Annualized Term Rates from Ameribor Futures
- Step 2: Term Rate Applications – Does all this math tie out?
- Step 3: Completing out the cash-flow-based, total P&L
- Step 4: Comments on hedge effectiveness
- LIBOR is history in less than 600 days
- As the transition goes for banks (other than the GSIB’s), AMERIBOR still makes more sense to me than SOFR.
- Trade systems are a HUGE issue going into the transition. And, it is very difficult to find a system that comprehensively supports the new benchmarks. The sole exception to systems issues: futures. Virtually all third-party vendors support Eurodollar futures and Fed Funds futures. AMERIBOR and SOFR futures have identical futures contract construction to ED$ and FF.
- The “test the systems” trade for the new benchmarks is easy: Where you have a short EDU0 future, move the position (or a piece of it) to SHORT MERU0 or SFRU0.
- This could be on a loan or securities hedge position or part of short position in the 6mo key-rate bucket for MSR hedges. If you want to dip your toe into a new benchmark, with little risk and a good possibility of saving a few basis points, try it with Sep’20 3mo Futures.
- We’re hearing issues with: Illiquid TBA trading with bid/asks reaching 4-5/32s from mid. Ultra-wide TBA-roll markets. Margin calls and cash whipsawing. Uncertainty on when loans will close. Fallout.
- With horrific liquidity in TBAs, and TBA options near impossible to source at any price, there is incentive to take mortgage:Treasury basis exposure.
- The proposed treasury option strategies can be simple: BUY a PUT OPTION—that’s it. Pay the premium for the option and there is NEVER a margin call.
- Want to see a full work-up of comparative cost analysis or have specific requests? Please reach out. Put Options on Treasury Futures are being deployed by an increasing number of our pipeline clients already. The mortgage:treasury basis risk is nothing compared to today’s costs of getting in and out of TBAs—and the insane cash requirements for margin calls.
- Own Swaps vs Treasuries in the belly: 5y-10y. Banks are way too short duration. They don’t have room for adding securities and why compete with the Fed to buy non-HQLA? Look for banks to load up LONG on swaps in the belly of the curve given advantage of posting initial margin vs actual balance sheet use.
- Own 20y-30y T. Treasury will focus issuance on front end of the curve to NOT undo the Fed’s QE buying impact on the longer duration securities, where the primary dealers need help.
- Curve will trade directionally. Once some semblance of liquidity is restored, I expect flattening.
- Softening U.S. dollar implies Fed swap lines are working. Begs the question why 3moLI remains so high relative to 1mo and 6mo. But, since short-term LIBOR rates are almost entirely hypothetical, it’s tough to trade this one.
- IG is cheap
- From 10/17/20 on, all cleared swaps and swap futures will change:
• PAI will switch from Fed Funds to SOFR
• Eurodollar Futures will continue to trade, subject to fallback triggers—at which point ED$s and ED$ options will convert to SOFR.
• Cleared swaptions, at this point, will be liquidated/PV’d—though discussion continues.
• Cash flow discounting will switch from OIS/FedFunds to SOFR
- Plenty of talk continues about repo and funding pressure subsequent to the September surge. Many of the best minds and most-veteran traders are warning that the Fed’s multiple patches are not enough. But how does an institution with risk hedge this exposure? Or, how does a smaller fund (without access to all forms of derivatives) protect or wager on year-end funding pressure?
The answer is, “Use SOFR futures.”
- 1mo SOFR vs Fed Funds. Many of the banks got their face blown off being the ‘wrong way’ on the SOFR/FF convergence trade in September. They were buying 1mo Sep SOFR and selling 1mo Sep Fed funds around -10 expecting a convergence to -8/-7. When the spread got there, they did not cover. With the repo surge, the spread blew out to -23bps and has thus been labeled, “the widow-maker”. This trade was akin to the TU/OIS trade that separated large cash from traders that thought ‘free carry’ and got educated on short discreet options.
- ATTN STIR TRADERS, TRANSITION TEAMS: Here’s a look at nine major U.S. short rates, all re-cast into a uniform basis. Using 1-month-in-arrears averaging, the problems in the financing market become crystal clear.
- As is often the case with new instruments—especially derivatives—pricing can get wonky due to relatively small directional flows pushing relationships out of whack. Back-month SOFR futures, specifically SFRH1 (Mar’21 3mo SOFR on CME), have outperformed September’19 2-year futures (TUU9). The overshoot in the relationship peaked last Monday (6/3)—along with the peak of inversion on the front-end of the yield curve.
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