Although the Federal Reserve Bank of New York has been publishing the Secured Overnight Financing Rate (SOFR) since April 3, 2018, SOFR’s popularity seems to be gaining momentum as of late.
On August 15, 2018 a headline in Bloomberg read, “New U.S. Overnight Rate Moves Out of LIBOR’s Shadow.” The article outlined major debt issues by Fannie Mae ($6B) and the World Bank ($1B) tied to the new rate.
Regulators expected SOFR to work alongside LIBOR for a few years, but the transition may be occurring faster than anticipated. According to analysts, World Bank and Fannie Mae, which are among the most sophisticated debt issuers, typically pave the way for others in the debt market. Their quick move to SOFR-linked issuance is a huge vote of confidence for the dollar-market alternative to LIBOR.
SOFR is a fully transaction-based rate with the widest coverage of any repo rate available and is a good representation of the general funding conditions of the overnight Treasury repo market.
Why Replace LIBOR?
LIBOR, or the London Interbank Offered Rate, had long been the standard for what banks charge each other for short-term loans and the benchmark for other debt instruments, like corporate loans and government bonds.
However, in 2014, in response to concerns regarding the reliability and robustness of LIBOR, the Federal Reserve Board, the Federal Reserve of New York, and partnering agencies moved to investigate alternatives. Specifically, there were concerns that LIBOR was:
Lacking credibility. Because the LIBOR rate is based on proprietary observations self-reported by banks, it is subject to manipulation. Before and during the 2007-2009 financial crisis, LIBOR faced charges of allowing banks to manipulate the rate to book larger profits on derivatives based on the rate.
Growing increasingly risky. In March 2018 it was reported that LIBOR underpins $200 trillion in derivatives, loans, floating rate debt, and securitizations. Derivatives contracts represent nearly 95 percent of this activity.
Declining in use. Reforms to banking and money market fund regulations resulted in fewer interbank short-term loans and reduced demand for bank debt. Major banks have stopped contributing their submissions.
Additionally, the United Kingdom’s Financial Conduct Authority and other public-sector officials have cautioned that LIBOR may not be available after 2021.
Why SOFR is the best replacement
In June 2017, after years of investigation and market input, a committee of private market participants called the Alternative Reference Rates Committee (ARRC), identified SOFR as the preferred alternative to USD LIBOR because it “represents best practice for use in certain new U.S. dollar derivatives and other financial contracts.”
SOFR is fully transaction-based and founded on a robust underlying market where about $800 billion is traded daily. Actual transaction-level data is provided by Bank of New York Mellon (BNYM) and an affiliate of the Depository Trust & Clearing Corporation, DTCC Solutions LLC. (You can read more about SOFR rate calculation here.) Further, SOFR complies with emerging standards such as the IOSCO Principles for Financial Benchmarks.
The transition to SOFR
To encourage adoption of SOFR, the ARRC has a Paced Transition Plan with an anticipated completion of YE 2021. But in its second major report, dated March 2018, the committee said that if ARRC members (big OTC derivatives players), key end users, and other market participants recognized their own interest in voluntarily helping to establish markets for SOFR instruments and build a critical mass in them, the transition plan would incorporate faster adoption timelines.
In addition to potentially revising its adoption times, ARRC is updating its transition plan to include the creation of a forward-looking term rate based on SOFR derivatives markets.
The ARRC’s monthly meeting notes show clear evidence of the committee’s progress. For example, a July 2018 letter to U.S. regulators pushed for confirmation that the following actions, integral to the interbank offered rates regulatory reform agenda, will not result in a change in regulatory status under the recently passed Dodd-Frank Wall Street Reform and Consumer Protection Act (Title VII):
- Amendment of derivatives contracts to include LIBOR fallback provisions
- Replacing LIBOR with alternative RFR for derivatives contracts
- New derivatives contracts referencing alternative RFRs
The committee is also making progress on new contract language and has working groups related to:
- Business loans and collateralized loan obligations
- Mortgages and other consumer loans
- Floating rate notes
According to ARRC, “contracts are beginning to be written with provisions that would allow for a choice of economically appropriate fallbacks should LIBOR cease publication. These preparations are crucial for financial stability, and require a clear, coordinated, and thoughtful process engaging with all market participants and involving the support of regulators.”
SOFR is still evolving
Yes, the ARRC still has plenty on its to-do list related to trading, swap contracts, and the creation of a term reference rate based on SOFR-derivatives markets. However, it’s not too soon for you and your colleagues to learn more about SOFR and how it will affect your business. Follow industry and association news, monitor the ARRC’s website, and of course, watch for updates from your Dashboard team in the coming months!