ARRC issues updated scope of use for CME Term SOFR derivatives
On April 21, the Alternative Reference Rates Committee (ARRC) issued an update to their scope of use and best practices for CME Term SOFR. Their announcement as well as links to these recommendations and scope are below.
The ARRC recognized that the limited scope of use for CME Term SOFR derivatives has created what the market refers to as Term SOFR basis. This basis began at one to three basis points and currently has expanded between six and nine basis points depending on the specific dealer and trade tenor. This incremental spread represents the amount of basis risk that dealers are warehousing on their balance sheets.
The ARRC formed a sub-committee to investigate possible other scopes of use for CME Term SOFR derivatives. However, the ARRC has historically been very deliberate in communicating it would not support CME Term SOFR derivatives trading in the interdealer market, and that all firms should primarily look to use overnight versions of SOFR like SOFR-COMPOUND or daily weighted average of overnight SOFR as indices for derivatives. In the fall of 2022, the ARRC began discussions on the idea of allowing the end user side of the market to enter into CME Term SOFR basis swaps without requiring it to be directly linked to a cash instrument. Those discussions seemed to have stalled until the recent news due to the ARRC seeing the inconsistent application of its scope and recommended use cases.
Summary of the ARRC's refinement
In the recent announcement, the ARRC introduced, “an additional limited, recommendation regarding Term SOFR-SOFR basis swaps: the ARRC now recognizes that a dealer may enter into Term SOFR-SOFR basis swaps with any non-dealer market participant, even if the market participant is not a direct party to a Term SOFR cash exposure.”
"An additional limited, recommendation regarding Term SOFR-SOFR basis swaps: the ARRC now recognizes that a dealer may enter into Term SOFR-SOFR basis swaps with any non-dealer market participant, even if the market participant is not a direct party to a Term SOFR cash exposure."
Impact on regional and community financial institutions
For many regional and community financial institutions, there are currently no direct applications to enter into a Term SOFR-SOFR basis swap. However, as market conditions continue to evolve, the improvements may provide an outlet for clients to manage this specific basis exposure efficiently. Some market experts predict that this refinement should help decrease the current basis as well as limit a further increase in the CME Term SOFR basis. The expanded use case could also eventually lead to CME Term SOFR swaps being centrally cleared.
The ARRC remains steadfast in not allowing the use of CME Term SOFR for derivatives in the interdealer market or outside of its scope of use and recommendations. Market participants thinking that more relief is on the way may be too optimistic. The ARRC stated in Friday’s announcement that it “does not intend to revisit its Best Practice Recommendations for the use of Term SOFR, which are meant to apply as permanent recommendations for the market."
Lastly, we wanted to highlight that many of our financial institutions clients have entered into receive-fixed and pay-CME Term SOFR swaps for balance sheet hedging purposes. This strategy takes advantage of the CME Term SOFR basis by allowing dealer banks to enter into offsetting trades and reduce their risk positions.
- ARRC Announcement of Update to Term SOFR Scope
- ARRC Summary and Update of the ARRC’s Term SOFR Scope of Use Best Practice Recommendations
- ISDA’s update on TERM SOFR
Please contact a Chatham representative to discuss how we can assist your institution.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.23-0103
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