(Bloomberg) -- More than a decade after the Libor-rigging scandal shocked the financial industry, derivatives traders in CME Group Inc.’s last open-outcry pit are finally shifting their focus to contracts based on the replacement for London Interbank Offered Rates.

The number of options on futures linked to the Secured Overnight Financing Rate, or SOFR, recently overtook the corresponding figure for eurodollar futures that settle at Libor rates.

The shift in leadership marks a major change for the hulking US interest-rate options market, a main vehicle for wagers related to Federal Reserve policy expectations and bond-market volatility. Yet even as this market steps into the future, CME’s sole surviving open-outcry trading pit — one of the last ones left in Chicago — is poised to continue being an essential venue for the complicated trades linked to SOFR. 

“The transition from Libor to SOFR doesn’t change the multi-legged nature of the activity,” which customers prefer to conduct by voice rather than electronically, said Don Wilson, chief executive officer of DRW Holdings LLC, the Chicago-based trading firm he founded in 1992. “Therefore the status quo is likely to persist.” 

The migration to SOFR futures and options is the result of the long-planned extinction of US dollar Libor next year. Beginning in 2008, Libor was found to have been manipulated by some European and US lenders tasked with contributing rates used in its calculations. SOFR, administered by the Federal Reserve Bank of New York, is based on the rates that institutional owners of Treasury securities pay to finance them overnight. 

The growth in trading of SOFR options follows a year in which CME Group, the exchange operator that lists both products, showered customers with financial incentives such as fee waivers to make the leap to SOFR futures and options from eurodollars, securing its franchise as the biggest sponsor of US interest-rate derivatives. 

Until this year, daily volume in SOFR options failed to breach 20% of eurodollar options volume. Since mid-June it’s consistently been higher. Combined volume in the products — which collapsed after the Fed slashed its policy rate to zero in early 2020 — has resurged with the return of higher interest rates and bond volatility.

SOFR options inhabit a world that’s both radically different — and fundamentally unchanged — from the one eurodollar options grew up in. 

Eurodollars — futures on the three-month Libor for dollars — debuted in 1981. By 1988, they’d become CME’s biggest product in terms of volume and open interest, with growth fueled by Libor’s proliferation as a reference rate for bonds, loans and other forms of credit, which eventually exceeded $200 trillion. As a short-term lending rate influenced by the Fed’s policy rate, Libor became a way to wager on the central bank’s policy path via options on eurodollar futures.

Unlike many other types of futures, where most trading is concentrated in just one or two contracts, eurodollar futures generated heavy volume for dozens of separate contracts with quarterly expiration dates years into the future. Options volume followed. 

Smaller Pit

CME open-outcry trading peaked in 2006, the year that the exchange merged with rival CBOT Holdings Inc., whose financial products included futures and options on Treasury securities. The trading pits for eurodollar futures and options — and the floor brokers clad in color-coded jackets — subsequently relocated to CBOT’s 60,000-square-foot trading floor.

But by March 2020, when CME temporarily closed the floor at the onset of the Covid-19 outbreak, eurodollar options were one of only about a dozen products that were still traded by voice in old-fashioned pits. Trading of the underlying eurodollar futures contracts had gone exclusively electronic, as had Treasury futures and most other products. 

Among the CME’s roughly 2,100 products, only the eurodollar options still generated enough floor business to warrant maintaining a pit when it was deemed safe to reopen. Floor trading resumed only for eurodollar and SOFR options in August 2020, in a pit that had been expanded and zoned for social distancing. In May 2022 it was relocated to a space that’s less than one-tenth of the size of the old floor, which was sold to Commonwealth Edison to house an electrical substation.

That’s an advantage, according to Tom Carideo, an interest-rate options market maker at WH Trading. 

“I can hear a lot better,” Carideo said. “The noise is only from our pit,” which is no longer surrounded by any others. “It makes it extremely efficient.”

CME has said it will offer floor trading as long as there’s adequate demand for it, and the fact that 63% of SOFR options changed hands in the pit last month suggests that open-outcry will survive the transition. During the five-month period when the pit was closed, stakeholders in electronic trading were hopeful it might never return. Instead, its survival is an object lesson in the limits of computerized strategies. 

The large array of possible combinations of options means that an electronic platform can’t easily display them all, said Terrence Belton, former head of fixed-income strategy at JPMorgan Chase & Co. and an adjunct professor of finance at the University of Chicago’s Booth School of Business.

It also makes the product similar to over-the-counter markets where trading by voice rather than an electronic alternative remains popular, such as Treasury securities other than the most recently issued ones, he said. There are hundreds of those, and there’s no at-the-ready market for every single one.

‘More Suitable to a Voice Broker’

“If somebody wants to do a very large option spread trade in out-of-the-money options — not the most liquid structure out there — that’s more suitable to a voice broker,” Belton said. “It’s not something you do without extra layers of risk management.”

Open-outcry trading of options on equity indexes and volatility has also fended off extinction at Cboe Global Markets, founded as the Chicago Board Options Exchange. This year, about 30% of options on the S&P 500 and 46% of options on the VIX, Cboe’s S&P 500 volatility index, have been handled via open outcry, according to the exchange.

Open-outcry remains a thorn in the side of electronic-trading stakeholders including Thomas Fitch, founder and CEO of RVAssets, which creates trading algorithms. The combined trading volume in eurodollar and SOFR options has yet to rebound to pre-pandemic levels, as Treasury options volume has. Open-outcry “is most definitely holding back the SOFR market,” he said.

In his view, it survives because while pit brokers are obliged to show prices to all pit participants, the desk brokers who send orders to the trading floor don’t have to show them on the electronic platform, which inhibits its growth.

Meanwhile, floor brokers who opt to split fees with the desk brokers that send them orders are engaging in a payment-for-order-flow model that “will only become increasingly unacceptable from a regulatory perspective,” Fitch said.

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