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The Race to SOFR: A New Benchmark Brings Opportunities

Further to the blog that we wrote previously on trading Sterling Overnight Index Average (SONIA) contracts, pressure is mounting on firms to drop London Interbank Offered Rate (LIBOR) as a standard. The Bank of England warned firms to stop writing new contracts using LIBOR – which will come to an end as of year-end 2021 – as a benchmark, echoing comments by John Williams, president at the New York Federal Reserve that firms were “sticking their metaphorical heads in the sand” on the issue.

As firms shift to trading derivatives using SONIA in the UK and the Secured Overnight Financing Rate (SOFR) in the US, the increase in liquidity and speed of trading is likely to create pressure on the trading infrastructure underpinning execution.

Low latency technology and automated trading strategies

That will have a direct impact on automated trading strategies. Spotting relative value trades in these markets will require a rapid feed of price data and equally fast execution capabilities to seize opportunities as and when they arise. Equally, firms seeking to arbitrage prices for liquidity taking and making between different venues will have to ensure they can get a single picture of market activity as they trade. The use of low-latency technology creates real opportunities for firms engaged in automated trading of SOFR contracts in both the futures and the cash markets.

US Treasuries as a cash instrument are already highly liquid; and firms trading in the dealer-to-dealer (D2D) market are almost entirely electronic, while 40% of the dealer-to-client (D2C) market still trades on the telephone, according to Greenwich Associates’ paper, ‘US Treasury Trading No Longer a Divided Market’ launched at the end of 2018.

However, it also found trading the lowest-cost execution option is becoming increasingly popular with banks now winning 60% of their buy-side trading volume based on best execution, up from 48% in 2015. Trading in European government bonds on the D2D market can also be a very fast, liquid market. Speed of execution is therefore imperative in both the D2D and D2C markets, and as the new contracts grow in volume, handling trading across both cash and derivatives will be challenging.

Using multiple trading systems will complicate the trading workflow, not only because manually switching between systems increases risk and the chance of errors being made, but also because any differences between systems in the latency of receiving, processing and pushing out trading messages could misalign execution opportunities and increase costs.

Making trading technology more reliable across multiple venues

Market participants that can execute trades using a single trading platform, with connectivity to government bond venues, futures exchanges and swap execution facilities, will be able to see their real position in real-time and can rely upon their automated trading systems to execute effectively as these markets grow.

As liquidity builds in new SOFR and SONIA futures contracts, driven by pressure from the central banks and regulators, there are likely to be greater opportunities for arbitrage between derivative and cash instrument markets. Ensuring that your trading technology stack is fully up-to-speed in its capacity to work across venues at low latency, will be a key determinant of your potential for success when executing automated trading strategies.