SOFR Options — How healthy is the market?
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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 Khwaja and Chris Barnes, we take a quick dive into the headlines on the Clarus blog.

Let's get started.

Hi, Amir. Hi, Chris. 

Amir Khwaja: Hi, Ali.

Chris Barnes: Hey, Ali. How you doing?

Ali Curi: I'm doing great. Welcome back to Quick Takes.

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

Chris Barnes: All right. This week, I'm going to try and talk all about options. The blog we'll focus on is called "SOFR Options — How Healthy is the Market?" but I've also recently started writing a quarterly review of swaptions activity as well.

So I thought it made sense to kind of highlight the fact that yes, we are introducing more and more options content. I think it continues to be a very, very interesting area of the market. I think it's naturally a little bit less transparent than underlying swaps. Mainly because swaptions are not cleared.

There isn't quite as much data out there. But also, I think, you know, from time to time, when you've written a lot of blogs, it's good to introduce a new subject. And so, I'm learning a little bit every time I write these blogs as well. So first point I wanted to raise is SOFR Options, right? We've obviously done a lot of blogs on RFR transition, the cessation of LIBOR, et cetera, but with that lens, we've never looked at the underlying options markets as well, obviously the options markets of transition.

So the point of this blog was really high level. We have the data on how big the Eurodollar options market was when LIBOR was a thing. We're now way past LIBOR cessation. Have software options markets caught up and are they now as mature as the Eurodollar markets used to be? When I wrote this blog, two things; one, somebody had told me in the market that software options were tidy. And so I was expecting to see a big lag between software options growing compared to the Eurodollar market. And also from a kind of anecdotal perspective, I expected software options to be smaller than Eurodollar options. Why? Very simple. Eurodollar options had a credit spread element, right? And so I remember back in crisis days, Lehman's, et cetera, Eurodollar would spike, right?

And then all of the options traders, whether it's through luck or bad judgment, all of that really "high-strike massively out of the money" options are suddenly getting a load of Delta associated with them. And so ever since then options traders would always talk kind of strategically about not wanting to sell exposure to a high strike options, trying to structure the books so that you were structurally long these tail events, then you fast forward to when we're in a real case of negative rates.

And whilst you might not have explicit flaws on loans, you suddenly might have implicit flaws on CSA agreements. And so how is that representing itself in terms of how you manage your strike exposure at these real tail events? And so I was kind of expecting a lot of the SOFR volumes we see to be lower than Eurodollar option historic volumes, because they don't have these esoteric facets about them.

However, when I look at the volumes, it's really fair to say that software options are a very, very healthy market that almost as large as Eurodollars were. Not quite there yet, but we've got time, right? They've developed very, very quickly. We've run some metrics looking at ratios of open interest, looking at ratios of volumes in options versus volumes in the underlyings, et cetera.

So I think there's a good structure there. There's a good structure on the blog to be able to follow how these volumes evolve, and also to compare these exchange-traded SOFR options. So I'm really talking about options on futures contracts here compared to the pure OTC market of swaptions and comparing how volumes in swaptions compared to volumes in swaps, comparing how volumes in SOFR options compared to volumes in SOFR linear stir.

And so what we tend to do on the swaptions side. Which is a different blog, that's "Swaptions Volumes by Strike." I'm writing this quarterly, is we're able to produce a heat map of activity so we can show the volumes that are traded per strike across all of the assorted tenors. That's obviously potentially quite a complex piece of analysis.

The blogs try and give you some kind of sound bites and some high level overviews about what has been happening. I wrote the Q1 blog back in May. I've actually just published this week, a Q2 blog as well. And we're trying to stay on top of this because we are now identifying straddles in the OTC data as well.

So Amir, I think this is probably the first time we've talked about options on the podcast. I think it's probably the first time that we've had an opportunity to have a bigger, a bit of back and forth on the markets. So interested to hear any of your thoughts or questions. 

Amir Khwaja: Sure, Chris. So I guess SOFR options on the future side, I think given SOFR has been flat since August 2023, about 5.3 percent, hasn't really moved more than 10 basis point, right? The odd spikes. So I think it's still pretty healthy volume given the underlying is not volatile. I think that's a really interesting point. I think, and then as we're adding more option data, looking at it more closely, your swaptions, I guess I was surprised why swaptions are not a bigger percentage of the underlying swap markets.

And that does beg the question, is it the fact that bilateral, not clear transparency of prices, our customers preferring exchange with the future options because of transparency, liquidity versus swaptions. 

Chris Barnes: Increasingly, I think it's all boiling down to the same thing now, in that reported volumes for swaps includes so much list trading, so much risk neutral movement of portfolios that I think we're almost in the stage now where it's really vital when you're talking about swaps volumes to strip out what is portfolio maintenance and what is price forming.

And I think when we look at these blogs on swaptions and cross-currency swaps, which are both bilateral markets, there is so much less portfolio maintenance activity. And so almost all of the trades you see are true price forming trades. And so I think it's really healthy for us to take a closer look at these markets and monitor the relative volumes in options markets compared to their underlyings. It doesn't necessarily mean that a reduction in that ratio is a bad thing. It could just mean there's even more non-price forming activity reported in swaps. 

Amir Khwaja: Good points, Chris. So I think those are things we try and strip out of the underlying swaps data. I think simply in the futures volume, there's a lot of day trading. Right? 

Chris Barnes: Exactly. 

Amir Khwaja: Open a position, close it that day. People are really selling short-dated options, maybe even closing every day, their positions. 

Chris Barnes: It's a question about narrowing down your metrics. So probably the ratio of open interest for futures markets of options versus the underlying is the most accurate representation of risk transfer and the health of the market.

And in OTC, you want to strip out non price forming activity in swaps and compare that to almost the whole of the swaptions market. 

Amir Khwaja: Agreed. 

Chris Barnes: So Ali, I'm thinking of doing more for options space. We've just had the release of €STR Options. We're looking at pulling in more data on SONIA Options as well. If any of the listeners, readers, wants us to focus on, let's say Euro swaptions, for example, more than happy to add, take out, input and look at these markets.

Ali Curi: Great. That works. Thank you, Chris. And please share with us again, the title of your blog post. 

Chris Barnes: So the options special today was centered around one blog. That's a "SOFT Options — How Healthy is the Market?" I do also make reference to my "Swaption Volumes by Strike," which is a quarterly review. 

Ali Curi: Perfect. Thank you.

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

Amir Khwaja: Thanks Ali. 

Chris Barnes: Thanks Ali. Look forward to next week. 

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 and on LinkedIn. 

Thank you for joining us.