The truth about SONIA derivatives liquidity
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Ali Curi: Hi everyone, and welcome to ION Markets Quick Takes. I'm Ali Curi, and every week, along with my guests, Amir Kwaja and Chris Barnes, we take a quick dive into the headlines on the Clara's blog. Let's get started. Hi Amir. Hi Chris. 

Amir Khwaja: Hi Ali. 

Chris Barnes: Hi Ali. How are you doing? 

Ali Curi: Doing great. It's great to have you here.

Chris, let's start with you. What are your Quick Takes for this week? Which headline from the Clarus FT blog would you like to discuss? 

Chris Barnes: Well, today I will be talking about a blog called, "Clarus Data Reveals the Truth About Sonia Derivatives." I'm not going to tell you what the blog says, because this is a podcast.

I think you should go off and read the blog yourself. What I'm going to do is probably have a little bit of a moan, because this blog is about SONIA liquidity. And I have to be honest, for as long as I can ever remember sitting on a trading desk, traders have moaned about the liquidity of the sterling rates market.

First thing you learn when you sit down on a rates desk back in the day when we still used to trade LIBOR, was that short sterling is a horrible market to trade. It's difficult. It's really hard. It gaps. It moves a lot. There aren't a lot of contracts. It's really difficult and it's fundamentally different to euros and dollars, which are much, much deeper.

And, you know, sterling is a G3 currency. It's one of the biggest rates markets out there, but you soon learn in your career that the market moves in sterling are very, very different to the market moves in euros and dollars. And so, when I still read in 2023 articles which are saying there's limited amounts of debt, it's difficult to trade in sterling rates, I'm like, "This is just not, this is just not news, and it doesn't really matter whether you were a trading LIBOR or whether you were impacted by the LDI crisis last year, et cetera." The sterling market is notoriously a difficult market to trade. And so what I wanted to try and do with a blog is say, look, it is possible to pull out data as a result of LIBOR transition that makes a rates market look worse then it did in 2020 or in 2019, even ignoring potential spikes for activity related to the pandemic and volatility and sell offs, et cetera, because fundamentally what's happened with the data is that the market structure has changed.

We have now moved from markets that in the whole we're trading across multiple indices, whether they be term indices or OIS indices to a single index world. And if you now only have one product to trade, volumes are going to be lower. That is a natural extension of the market structure changes as a result of LIBOR cessation.

Now, I think that is well understood, and so the biggest question that I had as a result of that was not whether OTC volumes would reduce, but what would the impact be on futures? Because a big driver of futures, particularly in markets like sterling has historically been hedging activity from the short end of the swaps market.

And so if that hedging activity from the short end of the swaps market disappears, what impact does it have on SONIA futures? As I said, I really want people just to go out and read the blog and try and understand the data, but I would say as a headline, generally speaking, the SONIA market actually looks very, very strong.

Amir Khwaja: Chris, you have a good point. So, you know, with basis swaps no longer trading, you know, LIBOR SONIA basis, 3, 6 LIBOR, et cetera, the swap market volumes have held up. With less products, do you feel there should be more liquidity now in swaps and futures given the simpler product sets, or will it be the same underlying demand from issuance and clients?

Chris Barnes: If you'd asked me back in 2022, before we'd had LIBOR cessation, probably would have said that futures looked particularly threatened as a result of LIBOR cessation. I did not expect the dollar SOFR contract to get to the same type of volumes as were traded in euro dollar. However, that's not what we've seen.

We now see just as much volume trading in SOFER futures as we used to do in euro dollar futures, I think that's a really, really telling statistic. I think when we looked on the Clarus blog of the transition as well from euro dollars, which contracts were physically converted into SOFER futures, just the sheer amount of netting that happened as a result of that process really shows the strength of having standardized products, which just simplifies your life.

That seems to have been the story that people are happy to trade these simplified products. They don't necessarily have to always trade a tailor made OTC product. So it seems to be an embedded feature of market structure now that futures and OTC are both here to stay. They both have their proponents and the relative balance and mix of risk that trades one versus the other is relatively stable, really. 

Amir Khwaja: Yeah, and that's interesting that from 2018 to now, the DV01 split between OTC and ETD has remained largely the same, right? Pre LIBOR, post LIBOR, which is interesting. So clearly there are market participants that prefer one over the other. 

Chris Barnes: Agreed. The one thing I'd say about futures is that probably says that you really just want that one single futures contract that is massively liquid, massively standardized. And that you don't split that either across multiple venues or multiple CCPs or across, for example, Fed funds and SOFR, it'd be better to just have one, etc.

Amir Khwaja: So good point. Is there still a battle for market share on the SONIA contract between futures exchanges, or is it, "don't read ICE now?"

Chris Barnes: This is another reason why the kind of the headlines about sterling rates and volumes being lower, and traders saying, yes, I really agree, it's a very difficult market, et cetera.

It's somewhat annoys me because the trading community had a real opportunity to decide where the pool of SONIA liquidity was going to be back in the days when LIBOR cessation was first announced. When we had competitor exchanges, we had SONIA contracts at Life ICE now, we had SONIA contracts at Curve Global who were cross margining against LCH Swaps.

I think that CME had a SONIA contract, et cetera, et cetera. And the market voted by market forces, right? And the SONIA contracts that won out from that competitive landscape was the one at ICE. And ICE continued to have 98 percent or whatever it is of market share for SONIA Futures. And that seems to be how futures contracts trade really.

It's all or nothing, right? 

Amir Khwaja: Yeah, liquidity wise. Are there any lessons we can draw from what will happen when EURIBOR goes away and ESTR is the only reference index for derivatives. 

Chris Barnes: I think the biggest lesson we've learned is one that the market will be just as big as your EURIBOR eventually. We've seen it in dollars, we've seen it in sterling now. Hopefully we'll see it in yen. I think the Euro ESTR market will eventually be just as big as the EURIBOR market. And secondly, it seems like the incumbent exchanges in this case, EURIBOR is traded at ICE, really do have a big, big competitive advantage in terms of keeping that franchise there, even during benchmark transition. And that's it. That's everything I had. So I'll hand back over to you, Ali. 

Ali Curi: Thank you, Chris. 

And please share with us the title of your blog post. 

Chris Barnes: That blog is called "Clarus Data Reveals the Truth About SONIA." And I recommend you all to go and read it right now. 

Ali Curi: Great. Thank you. That works.

Chris, Amir, thank you both for sharing your Quick Takes. Let's do it again next week. 

Amir Khwaja: Thank you, Ali. 

Chris Barnes: Thanks, Ali. 

Ali Curi: And that's our episode for today. You can read more about these topics on the Clarus blog, and you can follow Ion Markets on X, formerly Twitter, and on LinkedIn. Until next week, thank you for joining us.