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 price by-product markets akin to 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 normally worsens when volatility rises, nonetheless liquidity within the UK’s STIR futures throughout 2022 was particularly poor. Liquidity in some metrics akin to open curiosity and volumes has since improved as volatility has diminished, nonetheless our intensive market intelligence conversations recommend that many nonetheless imagine there’s additional to go when wanting ‘under-the-bonnet’ at one other key metric, market depth. Volatility continues to play a job, however maybe there’s an enchancment that may be made to assist construct additional market resilience.
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 Fee intently. They’re the inspiration of a a lot wider set of rate of interest derivatives each when it comes to pricing and liquidity, akin to 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 tougher and costly for market-makers to hedge danger, and means these flows can distort the swap market – probably making new mortgages costlier.
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 of financial coverage in addition to the reliability of alerts taken by coverage makers from market pricing.
A deep and liquid SONIA futures market ensures that forward-looking market pricing for Financial institution Fee displays a extra reasonable evaluation of market members’ imply expectations of the probably future coverage setting. The ‘Mini-Price range’ 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 line with the Financial institution’s Market Individuals Survey (MaPS) outcomes in the course of the ‘Mini-Price range’ for instance, market members ascribed a 3rd of the divergence between market pricing and Financial institution Fee 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 may additional amplify shocks within the monetary system.
Moreover, the first liquidity suppliers within the SONIA futures market are algorithmic merchants. Though algorithms help market liquidity in ‘regular’ occasions, producing excessive volumes in a short time, their propensity to ‘flip off’ throughout danger occasions can drain liquidity quickly in periods 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 price 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 recommended this was because of the 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 sort out inflation. Russia’s invasion of Ukraine and the ‘Mini Price range’ in 2022 additionally contributed to extreme market volatility.
Chart 1: Sterling STIR futures common high of ebook 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 anticipated to fall (see Chart 4). However in keeping with conversations with market members, UK STIR markets suffered to a better extent than different jurisdictions (see Chart 5). Comparatively, when the US STIR futures market underwent an identical risk-free price transition, it didn’t result in a cloth discount in liquidity. Provided that UK market members additionally don’t are likely to blame the UK’s risk-free price transition as the reason for the preliminary decline in liquidity or the continued poor market depth, there should 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 akin to open curiosity and volumes have improved markedly since 2022 (see Chart 2 and three). Certainly, open curiosity and volumes at the moment are broadly akin to the previous LIBOR days (adjusting for variations in LIBOR vs SONIA contract sizes), with volumes reaching report ranges just lately, supported by the prevalence of algorithmic merchants.
One other liquidity metric often called value affect additionally reveals a normalisation from the intervals of stress lately as volatility has fallen from its excessive ranges (see Chart 6).
Chart 6: The affect of trades on costs spikes in stress
Supply: BMLL.
Even market depth when adjusted for the prevailing ranges of volatility has improved every year since 2022 (see Chart 7). There may be subsequently little doubt that liquidity in lots of respects has improved materially. That is largely as a consequence of comparatively much less uncertainty over the longer term path of coverage charges, in addition to the intense volatility skilled in 2022 now more and more seen as within the ‘rear-view mirror’. A slowly rising variety of market-makers as a consequence of change incentives within the SONIA choices market have additionally aided SONIA futures liquidity by way of the associated hedging exercise between these markets. That stated, regardless of the enhancements, market depth stays materially decrease versus pre-hiking cycle ranges. It additionally extra steadily hits all-time low throughout danger occasions, giving the SONIA futures market an ongoing sense of fragility, suggesting there’s nonetheless diminished market participation exterior of the algorithmic merchants.
Chart 7: STIR futures market depth versus volatility for various time intervals
Sources: BMLL and Financial institution calculations.
Liquidity begets liquidity
Stress occasions should still be weighing on appetites for UK danger publicity. The transition from LIBOR to SONIA futures meant a lack of a credit score danger component that beforehand attracted basis-trading exercise, though that is additionally true within the US.
However as highlighted, sentiment in latest months across the SONIA futures market has notably improved, mirrored throughout a set of liquidity metrics. And if volatility stays in examine, it’s potential that liquidity will proceed its upwards pattern as extra liquidity begets extra liquidity. However there’s one notable component relating to the UK market particularly that would nonetheless be weighing on additional enhancements.
The subject of SONIA futures fragility continues to be steadily raised by market members, notably within the context of huge strikes in implied charges at occasions all through the mountaineering cycle. One query we regularly get requested by market contacts is whether or not important UK information releases akin to CPI and labour market statistics, that are paramount to informing expectations concerning the future path of Financial institution Fee, will revert to being launched throughout market buying and selling hours. Previous to Covid, key information releases have been at 09:30am, effectively throughout the SONIA futures market opening occasions. This meant the information hit the market when liquidity had already ‘woken up’ from the market open. Nonetheless, with the present arrange of the information releases being at 07:00am (initially moved as a result of Covid made safe press briefings not potential, subsequently made everlasting) some recommend the market open sees exacerbated value ‘gaps’, with algorithmic market-makers ‘switching off’, and the normal financial institution market-makers concurrently lacking out on the surge in volumes they may expertise in the course of the normal value discovery course of round such occasions. This isn’t the case throughout different jurisdictions such because the US and EA, which each have important information releases inside buying and selling hours. Some contacts recommend that this issue continues to have an effect on participation and therefore liquidity, with market-making in UK by-product markets probably much less engaging versus different worldwide markets, and end-users unable to effectively hedge their danger in response to key information 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 intense volatility as decreased. The important thing query nonetheless is whether or not there’s something extra that may be accomplished to hurry up additional enhancements and encourage better participation. Altering information launch occasions might not be a ‘silver bullet’ nonetheless. Some available in the market could even want to have longer to consider what the information means for the probably path of coverage, and there’s maybe some public profit in information releases hitting the morning information headlines earlier. However it’s no less than 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 because of Joel Mundy for information and analytics who works within the Financial institution’s Market Intelligence and Evaluation Division.
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