The adoption of Risk Free Rates (RFRs) has impacted FX Swaps pricing and driven demand for more flexible, robust and configurable pricing technology.
The continued adoption of RFRs
The start of 2022 brought with it a large uptick in the adoption of RFRs. Levels of adoption vary across currencies, but with USD (SOFR) and GBP (SONIA) two large markets show high levels of use. A good source to track progress is the ISDA-Clarus RFR Adoption Indicator, which shows trading in cleared OTC and exchange-traded interest rate derivatives that reference RFRs. This hit a high of nearly 44% in April 2022.
This change to RFRs has led to a necessary transition in the pricing models used for FX Swaps. The LIBOR-based instruments like IRS or some of the STIR Futures could not continue to serve as the foundation, and instead overnight rates needed to be extracted directly from instruments with an RFR underlying.
The impact on FX Swaps pricing
The main challenge presented by this change is not a mathematical one. In fact, reducing the number of indices that need to be simultaneously calibrated per currency often reduces the complexity of the system. No longer does the FRA/OIS-basis need to be managed and monitored to build the overnight curve.
At DIGITEC we observed that the main challenge (and therefore the cost) of this transition in the pricing model was vastly different depending on the quality of the pricing system in place. Systems with non-configurable defaults or those that relied heavily on hand-crafted formulas, such as Excel-based system, are proving to be a bottleneck in this phase. This transition comes at a time when we see bid-offer spreads at record lows. The market has become so competitive that near-choice prices are necessary to compete for the business of the end-client.
The challenges presented by these extremely tight spreads become obvious in times of market movements. In the past, small movements were usually covered by the trader’s bid-offer spread, giving them time to react and adjust. In the liquid currencies that show these tight spreads today, this cushion has now been largely eliminated, especially with high levels of volatility in the market created by central bank activity.
Better pricing models using data from multiple asset classes
This leads to a need for faster pricing models that quickly adjust when the market starts to move. Models that solely rely on FX Swap prices published by brokers are particularly vulnerable, as these data points are not only among the last to update in times of movement, they also do not cover relevant points such as the central bank dates that show the largest effect.
Modern pricing models require the speed and accuracy that can only be found in efficient and transparent markets. A reliable source for such data is the STIR Futures market. Instruments like the one-month and three-month USD SOFR Futures or the still prevalent three-month EURIBOR Futures need to form the backbone of FX Swaps pricing. They do however need to be supplemented with market data from other assets, creating the need for a pricing model that is able to combine multiple assets into a cohesive model. While the short end of the curve is based on Futures, the long end required to price Cross-Currency Swaps will need to be built out of Swaps. Here, the effect of the LIBOR transition can again be observed.
Previously, practically all the liquidity was found in the IRS market. With LIBOR being phased out, this is changing. Some markets, such as GBP, already show almost all liquidity in long-dated OIS, while others are transitioning (USD) or lagging behind (EUR). This highlights the need to be able to quickly adjust the pricing models once the liquidity has shifted. The central output of this model is an overnight curve that combines sudden shifts at central bank dates with a smoother curve in other places.
Building accurate interest rate curves using market data is far from trivial. A good system however will make this process easier by quality checking inputs then presenting the trader with pre-configured market conventions, requiring minimal manual intervention after the initial setup. This includes automatic inference of the currently prevalent central bank hikes and cuts, cross-asset validation and control of the prices made available to e-trading.
Managing capacity
Modern real-time pricing models not only need to be easily configurable, but also need to be able to cope with the high number of updates coming from data sources such as Futures. This comes on top of the computationally more demanding pricing of RFR indices (with daily granularity), as opposed to the typical three-month LIBOR. Pricing engines not specifically designed for these capacity challenges can grind to a halt when put under this load, as is often the case for those based on Excel.
Increased global access to FX Swaps pricing
In the past, building a cross-asset pricing model optimised for real-time pricing/e-trading coupled with a user interface that enables multiple traders to work efficiently has been a costly and lengthy endeavour. Such a setup has therefore been out of reach for many of the mid-size and regional FX Swaps Market Makers until now.
Use of the Cloud has increased access for a larger group of Market Makers around the world, removing the need to rely on Excel. At DIGITEC we have made D3 available as an easy-to-integrate SaaS solution, further reducing the need for expensive development work. Tools such as D3 allow for the construction of pricing models in a no-code fashion. It exposes the latest pricing methods via modular building blocks, letting a quant or trader focus on building an accurate pricing model that works for their institution. The required speed, correctness and market standards are baked in.
The pricing models are exposed to the trader’s day-to-day usage via the D3 sheets module, which has been honed over many years to ensure fast access to prices and efficient management of multiple currencies at once.
And finally…..
Driven by RFRs and tight bid/offer spreads, combined with the need to capture and process ever more data from multiple asset classes, the pace of change in FX Swaps is accelerating. Using Excel or relying on old inflexible systems is no longer acceptable, in a world where even smaller Market Makers are now implementing more flexible, robust and configurable pricing technology.
