Caring for the ‘future’ – Financial institution Underground

David Glanville and Arif Merali

Brief time period rate of interest (STIR) futures are the bedrock of rate of interest markets, used to cost expectations of central financial institution coverage charges and different UK charge by-product markets resembling swaps and choices (see Determine 1). They’re key for the transmission of financial coverage and supply an avenue for rate of interest danger hedging which is necessary for monetary stability. Monetary market liquidity often worsens when volatility rises, nonetheless liquidity within the UK’s STIR futures throughout 2022 was particularly poor. Liquidity in some metrics resembling open curiosity and volumes has since improved as volatility has decreased, nonetheless our intensive market intelligence conversations recommend that many nonetheless imagine there may be additional to go when wanting ‘under-the-bonnet’ at one other key metric, market depth. Volatility continues to play a job, however a reversion to publishing key knowledge releases inside market hours might assist to construct liquidity additional.

Determine 1: SONIA futures underpin liquidity throughout a spread of sterling derivatives

What are SONIA futures?

SONIA (Sterling In a single day Index Common) is the risk-free rate of interest benchmark within the UK, and markets transitioned to SONIA from the contaminated sterling LIBOR index on the finish of 2021. SONIA futures are a subset of STIR derivatives contracts utilized by market members to handle rate of interest danger or speculate on strikes in SONIA, which tracks Financial institution Price intently. They’re the inspiration of a a lot wider set of rate of interest derivatives each when it comes to pricing and liquidity, resembling rate of interest swaps utilized by banks and constructing societies as references for fixed-term mortgages. Banks and constructing societies offset or ‘hedge’ their mortgage exposures within the swaps market by way of market-makers, who themselves usually hedge their ensuing rate of interest danger within the SONIA futures market. If SONIA futures are illiquid, it’s harder and costly for market-makers to hedge danger, and means these demand/provide imbalances can distort the swap market – doubtlessly making new mortgages dearer.

SONIA futures and financial coverage

Due to their significance for the pricing of rate of interest swaps and mortgage charges, SONIA futures are extremely influential on the transmission for financial coverage in addition to for the reliability of indicators taken by coverage makers from market pricing.

A deep and liquid SONIA futures market ensures that forward-looking market pricing for Financial institution Price displays a extra reasonable evaluation of market members’ imply expectations of the probably future coverage setting. The ‘Mini-Finances’ on the finish of 2022 and the 2020 ‘dash-for-cash’ episodes are two examples of when the SONIA futures market dislocated materially from what market members noticed as an applicable reflection of fundamentals. In response to the Financial institution’s Market Individuals Survey (MaPS) outcomes throughout the ‘Mini-Finances’ for instance, market members ascribed a 3rd of the divergence between market pricing and Financial institution Price expectations to ‘market illiquidity and technical components’.

SONIA futures and monetary stability

Rate of interest derivatives together with SONIA futures are used extensively by each banks and non-bank monetary establishments to hedge rate of interest danger, and when liquid, allow the environment friendly switch of that danger throughout the monetary system, thereby aiding monetary stability. Derivatives markets are closely interconnected with one another and different core UK markets such because the gilt market, which might additional amplify shocks within the monetary system.

Moreover, the first liquidity suppliers within the SONIA futures market are algorithmic merchants. Though algorithms assist market liquidity in ‘regular’ occasions, producing excessive volumes in a short time, their propensity to ‘flip off’ throughout danger occasions can drain liquidity quickly during times of volatility as they don’t have any obligation to offer costs.

Liquidity in SONIA futures

At the beginning of the mountaineering cycle on the finish of 2021, which coincided with the timing of the risk-free charge transition to SONIA, liquidity throughout a spread of metrics (market depth, open curiosity, and volumes) notably worsened, and this continued into 2022 (see Charts 1, 2 and three). Some advised this was as a result of transition itself, nonetheless most market members decided that the decline was primarily a results of the substantial enhance in rate of interest uncertainty and volatility as central banks globally readjusted financial coverage settings to deal with inflation. Russia’s invasion of Ukraine and the ‘Mini Finances’ in 2022 additionally contributed to extreme market volatility.

Chart 1: Sterling STIR futures common high of guide market depth by contract group

Sources: BMLL and Financial institution calculations.

Chart 2: LIBOR and SONIA Open Curiosity

Supply: Bloomberg.

Chart 3: LIBOR and SONIA Quantity (Rolling 30-day common)

Supply: Bloomberg.

After all, as volatility and uncertainty rise to excessive ranges, market liquidity is predicted to fall (see Chart 4). However in line with conversations with market members, UK STIR markets suffered to a larger extent than different jurisdictions (see Chart 5). Comparatively, when the US STIR futures market underwent the same risk-free charge transition, it didn’t result in a fabric discount in liquidity. On condition that UK market members additionally don’t are likely to blame the UK’s risk-free charge transition as the reason for the preliminary decline in liquidity or the continuing poor market depth, there are prone to be different UK-specific components that have been, and maybe nonetheless are, at play.

Chart 4: The connection between market depth and volatility

Sources: BMLL and Financial institution calculations.

Chart 5: STIR futures open curiosity throughout jurisdictions (listed to 100)

Supply: Bloomberg.

Below the bonnet illiquidity

Headline measures of SONIA futures liquidity resembling open curiosity and volumes have improved markedly since 2022 (see Chart 2 and three). Certainly, open curiosity and volumes are actually broadly corresponding to the outdated LIBOR days (adjusting for variations in LIBOR vs SONIA contract sizes), with volumes reaching report ranges lately, supported by the prevalence of algorithmic merchants.

One other liquidity metric often known as worth influence additionally reveals a normalisation from the durations of stress lately as volatility has fallen from its excessive ranges (see Chart 6).

Chart 6: The influence of trades on costs spikes in stress

Supply: BMLL.

Even market depth when adjusted for the prevailing ranges of volatility has improved annually since 2022 (see Chart 7). There may be due to this fact little doubt that liquidity in lots of respects has improved materially. That is largely on account of comparatively much less uncertainty over the long run path of coverage charges, in addition to the acute volatility skilled in 2022 now more and more seen as within the ‘rear-view mirror’. A slowly growing variety of market-makers on account of alternate incentives within the SONIA choices market have additionally aided SONIA futures liquidity by way of the associated hedging exercise between these markets. That mentioned, regardless of the enhancements, market depth stays materially decrease versus pre-hiking cycle ranges. It additionally ceaselessly hits very low ranges throughout danger occasions, giving the SONIA futures market an ongoing sense of fragility in comparison with different markets, suggesting there may be nonetheless diminished market participation outdoors of the algorithmic merchants.

Chart 7: STIR futures market depth versus volatility for various time durations

Sources: BMLL and Financial institution calculations.

Liquidity begets liquidity

Stress occasions should be weighing on appetites for UK danger publicity. The transition from LIBOR to SONIA futures meant a lack of a credit score danger ingredient that beforehand attracted basis-trading exercise, though that is additionally true within the US.

However as highlighted, sentiment in current months across the SONIA futures market has notably improved, mirrored throughout a collection of liquidity metrics. And while volatility stays in examine, it’s probably that liquidity will proceed its upward pattern as confidence and participation available in the market improves – liquidity begets liquidity. Nonetheless there may be one notable ingredient concerning the UK market particularly that would nonetheless be weighing on additional enhancements.

The subject of SONIA futures fragility continues to be ceaselessly raised by market members, significantly within the context of enormous strikes in implied charges at occasions all through the mountaineering cycle. One query we regularly get requested by market contacts is whether or not vital UK knowledge releases resembling CPI and labour market statistics, that are paramount to informing expectations concerning the future path of Financial institution Price, will revert to being launched throughout market buying and selling hours. Previous to Covid, key knowledge releases have been at 09:30am, nicely throughout the SONIA futures market opening occasions. This meant the info hit the market when liquidity had already ‘woken up’ from the market open. Nonetheless, with the present arrange of the info releases being at 07:00am (initially moved as a result of Covid made safe press briefings not doable, subsequently made everlasting) some recommend the market open sees exacerbated worth ‘gaps’, with algorithmic market-makers ‘switching off’, and the standard financial institution market-makers concurrently lacking out on the surge in volumes they may expertise throughout the regular worth discovery course of round such occasions. This isn’t the case throughout different jurisdictions such because the US and EA, which each have vital knowledge releases inside buying and selling hours. Some market members recommend that this issue continues to have an effect on participation and therefore liquidity, with market-making in UK by-product markets doubtlessly much less enticing versus different worldwide markets, and end-users unable to effectively hedge their danger in response to key knowledge releases while the market is closed.

It’s in everybody’s curiosity that UK short-term rate of interest markets are as deep and liquid as they are often to make sure environment friendly financial coverage transmission and monetary stability, and many progress has been made on this regard as the acute volatility as decreased. The important thing query nonetheless is whether or not there may be something extra that may be completed to hurry up additional enhancements and encourage larger participation. Altering knowledge launch occasions might not be a ‘silver bullet’ nonetheless. Some available in the market might even choose to have longer to consider what the info means for the probably path of coverage, and there may be maybe some public profit in knowledge releases hitting the morning information headlines earlier. However it’s at the very least a query price contemplating if a reversion to the pre-Covid norm may encourage a more healthy eco-system of members within the SONIA futures market and different associated markets.

David Glanville works within the Financial institution’s Sterling Markets Division and Arif Merali is a Senior Advisor throughout the Markets Directorate.

With due to Joel Mundy for knowledge and analytics who works within the Financial institution’s Market Intelligence and Evaluation Division.

If you wish to get in contact, please electronic mail us at bankunderground@bankofengland.co.uk or go away a remark under.

Feedback will solely seem as soon as authorized by a moderator, and are solely printed the place a full identify is equipped. Financial institution Underground is a weblog for Financial institution of England workers to share views that problem – or assist – prevailing coverage orthodoxies. The views expressed listed here are these of the authors, and will not be essentially these of the Financial institution of England, or its coverage committees.