By Daniel Kruger 

Traders in the futures market are beginning to embrace the Federal Reserve's proposed replacement for the troubled London interbank offered rate.

The same can't be said for companies issuing new debt.

Open interest in one-month interest-rate futures tied to the new secured overnight financing rate, or SOFR, more than doubled between August and December to about 375,000 contracts on the Chicago Mercantile Exchange.

Meanwhile, companies issued just $5.3 billion in floating rate notes linked to SOFR in December, about one-tenth of August's peak level.

The discrepancy in how traders and companies are adopting SOFR reflects the complexity of the transition process to a new benchmark for variable-rate debt.

Libor is a reference rate that has been used for decades and is linked to trillions of dollars of financial contracts, ranging from home mortgages to company credit lines. But financial firms and regulators around the world are preparing to stop using the benchmark at the end of next year after it fell into disrepute a decade ago following a manipulation scandal.

A committee of banks, investors and regulators convened by the Federal Reserve Bank of New York is trying to persuade companies to adopt SOFR, which is derived from rates for overnight cash loans in the market for repurchase agreements, also known as repo.

Getting companies to sell securities tied to the new rate and investors to buy and trade them is a challenge. Banks, companies and investors want a rate that reflects the risks from short-term lending, is supported by a liquid market and behaves in a predictable manner. Properly setting lending rates can determine whether loans are affordable for borrowers and profitable for lenders.

The rise in futures trading, and the decline in floating-rate debt sales, linked to SOFR coincide with turbulence in the short-term funding market. A September spike in repo rates jolted SOFR rates higher, and a series of interest-rate cuts by the Fed subsequently pushed them lower.

Before then, futures trading "was growing, but it really accelerated meaningfully after the September blowup in repo," said Mark Cabana, an interest-rate strategist at Bank of America Corp.

Some traders used SOFR futures to help hedge volatility in the repo market after a shortage of cash available to borrow overnight led to an unexpected spike in those rates in mid-September to 10% from about 2.25%. This led to a brief jump in SOFR to a record 5.25%, also from roughly 2.25% before the surge.

"Having a more transparent window into the repo market is a huge bright spot," Mr. Cabana said.

However, the pace of growth in the futures market could accelerate if there were more debt securities linked to the new rate, some investors and analysts said. That is because it would create an additional need for some investors to hedge against moves in prices and yields on the debt.

"For there to be actual volume, there needs to be meaningful debt issuance in SOFR," said Eric Donovan, managing director and head of foreign exchange and interest rates at INTL FC Stone.

The recent interest-rate cuts by the Fed have made investors less interested in floating-rate debt. The decision by a large issuer of SOFR-linked debt, the Federal Home Loan Bank, to scale back such sales was also responsible for much of the decline in issuance.

The recent volatility of the repo market is also making it difficult for some companies to gain comfort with SOFR, analysts said. Although SOFR's supporters say it is less volatile than Libor when the rate is averaged over a three-month period, it has been prone to spikes at the ends of months and quarters.

"That makes it hard for people who are not familiar with the market to understand" how it will behave over time, said Subadra Rajappa, head of U.S. rates strategy at Société Générale.

Royal Dutch Shell PLC last month became one of the early movers to the new benchmark. The company entered two revolving credit lines totaling $10 billion linked to SOFR, replacing an earlier Libor-linked credit line. By switching to the new benchmark, the company is trying to avoid any problems with the transition. The decision reflected the anticipation that Libor will fall from use, the firm said in a statement.

Shell's decision is notable as most companies haven't perceived an urgency to switch to the new benchmark two years ahead of the deadline. Although finance officials at large companies expect Libor to become obsolete, few say they see a need to make a change now, according to bankers who have discussed the matter with them.

Write to Daniel Kruger at Daniel.Kruger@wsj.com

(END) Dow Jones Newswires

January 07, 2020 08:14 ET (13:14 GMT)

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