Investors are starting to trade complex derivatives tied to the Federal Reserve’s preferred replacement for the London interbank offered rate, a sign the financial industry is coalescing around a new benchmark for short-term interest rates.
Banks and exchanges are expanding a market for secondary financial products tied to this rate—the secured overnight financing rate, or SOFR—easing worries that lenders and other financial institutions remain underprepared for the shift.
The CME Group this month began offering options on SOFR interest-rate futures and nearly two dozen SOFR options contracts have traded since the Jan. 6 launch. And JPMorgan Chase & Co. recently sold its first option allowing a client to enter a so-called interest-rate swap tied to SOFR, at a future point in time.
“This is a good step forward towards developing SOFR derivatives markets,” said Gil Holmes, head of global nonlinear-rates trading and co-head of North America rates trading at J.P. Morgan.
The latest developments build on the growth of futures and swaps markets launched by the CME Group in 2018. Average daily volume of SOFR futures contracts has exceeded 33,000 so far in January, a jump of 75% from January 2019, according to CME. Data shows swap volumes rising throughout 2019 as well. The cumulative notional value of CME SOFR swaps traded through December 2019 was $44.4 billion.
That is encouraging to some analysts because the transition marks a key shift for financial markets. Libor underpins trillions of dollars worth of adjustable-rate financial contracts, from corporate loans to home mortgages. The benchmark, which took decades to work itself into the financial system, was slated for replacement by the end of 2021.
“If this transition is to be successful, then it’s not enough for just a swaps market to develop,” said Timothy High, a senior interest-rates strategist at BNP Paribas. “You will need other derivatives markets and options products in SOFR form.”
Created by a Federal Reserve committee of regulators, banks and asset managers, SOFR was designed to be more reliable than Libor. While Libor is derived from estimates of what it costs banks to borrow from one another over different short-term periods, SOFR is based on the cost of transactions in the market for overnight repurchase agreements, or repos. That is where financial companies borrow cash overnight using U.S. government debt as collateral.
Derivatives trading is particularly important for SOFR’s acceptance in the market because investors, asset managers and corporate treasurers commonly use them to protect against potential losses from things including swings in interest rates.
About $190 trillion of the $200 trillion in financial deals linked to Libor are in derivatives contracts, according to the New York Fed.
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—Daniel Kruger contributed to this article.
Write to Julia-Ambra Verlaine at Julia.Verlaine@wsj.com
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