SOFR forward curve update and the CCP "Big Bang"

Chatham’s SOFR forward curve

As we’ve discussed previously, an interest rate forward curve for a market index is, at a discrete moment in time, a graphical representation of the market-clearing forward rates for that index, as derived from observable market data. SOFR markets are much less liquid than LIBOR markets, with significantly less trading volume, as we detail each month in our SOFR transaction activity updates. The methodology Chatham used in generating our initial SOFR forward curve, which we began publishing in 2018, constructed the curve based on five years of SOFR futures data, where transaction activity was greatest, and permitted the curve to jump on Federal Open Market Committee (FOMC) announcement dates to reflect the behavior of the underlying SOFR rate.

Chatham’s new forward curve methodology bases our curve upon the most liquid combinations of SOFR (daily rates and futures), the Federal Funds Overnight Indexed Swap Rate (OIS), 3-month LIBOR, and SOFR-Fed Funds and Fed Funds-3-month LIBOR basis swaps. The front end of the SOFR curve is based on SOFR futures while the rest of curve is based on a combination of Fed Funds and LIBOR data, resulting in a forward curve that projects spot SOFR and from which 30-day average SOFR and other conventions can be calculated. By incorporating Fed Funds instruments in the SOFR curve build process, the curve construction draws upon the more robust Fed Funds and LIBOR markets.

We expect to modify our methodology to derive our term SOFR curve again, likely in 2021, to reflect daily SOFR rates, SOFR futures, and SOFR OIS, assuming the market continues to develop as many expect.

The CCP discounting switch/“Big Bang”

CME and LCH are the leading clearinghouses (CCPs) that sit between parties to cleared derivatives, as compared with the uncleared over-the-counter (OTC) markets where most end users execute their derivatives transactions. On October 16, 2020, the CCPs will substitute SOFR for Fed Funds OIS in their discounting methodology for purposes of valuing cleared USD interest rate swaps and interest due on the collateral held against these positions (price alignment interest, or PAI). This discounting switch is a pivotal step in the Alternative Reference Rates Committee's (ARRC) Paced Transition Plan for developing SOFR markets and marks a major milestone in the eventual discontinuation of USD LIBOR, similar to changes CME and LCH made for EUR cleared swaps in July 2020.

Chatham’s valuation model and infrastructure support this market change on all affected cleared USD LIBOR swaps. This transition will impact parties to cleared swaps by introducing SOFR discounting risk, as compared with their current exposure to Fed Funds discounting risk, and the transition will impact the value of existing positions. For parties to uncleared OTC derivatives, we will follow guidance on appropriate valuation methodology and industry practice to determine the appropriate discounting methods for uncleared trades, with the expectation that they eventually will move to SOFR discounting. If this occurs, Chatham will provide advance notice to clients in connection with making this discounting change for OTC derivatives.

The future of forward-looking term SOFR

One of the key challenges in the transition from LIBOR to SOFR is the lack of term structure, meaning parties to SOFR-based loans or hedges have to incorporate various backward-looking calculations that are challenging from an operational and technology perspective. According to their Paced Transition Plan, the Alternative Reference Rates Committee (ARRC) intends to create a term SOFR market within the first half of 2021 and issued a Request for Proposals seeking an administrator to publish forward-looking term SOFR.

Both ARRC-recommended LIBOR fallback language and the approaches laid out by Freddie Mac and Fannie Mae contemplate the eventual use of a term SOFR.