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Libor to SOFR Switch Will Be Challenging

Response to CME’s SOFR futures contracts may provide early signal.

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Capital Markets

Corporate SOFR Usage on Horizon

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November 30, 2018

SOFR roll out makes progress toward addressing cash products

BenjaminsThe introduction earlier this year of a benchmark to replace Libor has so far offered little of practical relevance to corporates and others using the floating-rate debt markets as a source of financing, although there are recent indications of progress in that direction.

Most of the steps taken so far to develop the Secured Overnight Financing Rate (SOFR) as a replacement for Libor, the benchmark for $200 trillion in financial products, have been geared toward developing a deep and robust derivatives market, thus establishing an infrastructure to trade SOFR referencing instruments.

CME-listed, three-month SOFR futures contacts (SFRA) are starting to offer limited liquidity past two-year maturities, said Yon Valtchev, a fixed-income and credit-risk expert at Bloomberg. Speaking at the NeuGroup’s Assistant Treasurers’ Leadership Group (ATLG) meeting in early November, he added that the first cleared swaps based on SOFR were transacted in October of this year.

Those are critical developments, since the futures and cleared swap markets are essential to the creation of an active derivatives market that allows issuers, borrowers and hedgers to meet and actively manage their SOFR-based exposures, Mr. Valtchev said.

The first cleared OTC swaps priced off SOFR traded in October among five market participants. Responding to a meeting participant’s query about whether it was possible to generate swap prices from current market activity, Mr. Valtchev said the swap market remains “very limited,” and swap pricing must still be derived from how SOFR futures contracts are trading.

Nevertheless, CME and The ICE developed the capability to clear SOFR-based derivatives earlier than anticipated, and these transactions are the early steps toward developing more bespoke OTC swaps. Notable progress has also been made in terms of issuing debt priced off of SOFR.

Governmental institutions including the World Bank, Fannie Mae and the MTA have issued several billion of USD-denominated SOFR bonds, and large financial institutions including Wells Fargo and MetLife have also jumped on board with recent issues.

Toyota Motor Credit Corp. (TMCC) appears to be the first corporate stepping into SOFR waters, issuing $500 million in three-month commercial paper priced off SOFR on Oct. 25.

"Given TMCC's position as the largest non-bank direct U.S. commercial paper program issuer, we felt it was important to be involved early on in working with our investors," said Nicholas Ro, treasury national manager of sales and trading for Toyota Financial Services, in a statement. "In order to successfully transition from Libor to SOFR, we need to listen to the 'voice of our customers.'”

He added that gathering investor feedback allows the company to better serve its investors and understand their views on the new reference rate and “how investors feel about the alternative reference rate transition, and to determine what role TMCC can play."

Another major affirmation of SOFR may arrive in the near future from the US Treasury. Mr. Valtchev noted that the Treasury Borrowing Advisory Committee, an advisory committee governed by federal statute and consisting of members of investment funds and banks, has suggested that US Treasury look into offering SOFR referencing debt instruments.

“It’s my understanding that such and debt issuance is currently being evaluated, but no specific timeline is being proposed,” Mr. Valtchev said.

Cash products including loans and CP make up a mere 5% of the $200 trillion in Libor-based products. However, they are forward-looking term products giving borrowers a clear understanding of the amount and timing of future interest payments. Not so with SOFR. It is generated from upwards of $800 billion in overnight repurchase agreement-related transactions and doesn’t provide that forward-looking term structure.

The Alternative Reference Rates Committee (ARRC), the New York Fed-sponsored group that selected the SOFR rate to replace Libor, plans to propose a term version of SOFR, which would enable commercial and consumer borrowers to know what payments are due on specific dates in the future, similar to the situation today under LIBOR. Previous proposals for term that ARRC reviewed were deemed unsuitable.

Corporates and other organizations taking on large volumes of floating-rate debt often want to hedge those exposures, and the inability to receive hedge-accounting treatment under current accounting guidelines could stall some Libor borrowers from making the transition to SOFR. Mr. Valtchev told ATLG members that FASB has been analyzing the use of SOFR as a benchmark for interest-rate hedging and is anticipated to issue a policy statement.

The standard setter issued an Accounting Standard Update (ASU) Oct. 25 that expands the list of US benchmark interest rates to include a SOFR benchmark rate for hedging accounting.

“The new ASU adds the OIS rate based on SOFR as a US benchmark interest rate to facilitate the LIBOR to SOFR transition and provide sufficient lead time for entities to prepare for changes to interest-rate risk hedging strategies for both risk management and hedge accounting purposes,” FASB noted in its announcement of the change.
John Pappas, a FASB spokesman, noted that the ASU applies to new transactions. He added that the board recently added a new project to its agenda that will consider changes to generally accepted accounting principles (GAAP) required by the move to SOFR and away from Libor. The project will address how to account for existing transactions should Libor become no longer available and require “falling back” to SOFR.

“The FASB is working closely with the ARRC and ISDA (International Swaps and Derivatives Association) to monitor the transition and act as necessary to facilitate that transition to SOFR,” Mr. Pappas said.

Significant progress has also been made on “fallback” language should The ICE no longer be able to publish Libor before or after the end of 2021, when banks are no longer required to provide information about what they charge on another for large loans. Comments on the ARRC’s proposal for fallback language related to syndicated loans and floating-rate notes were due November 26, and comments on ISDA’s fallback language for derivative contracts were due October 25.

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