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Capital Markets

Libor to SOFR Switch Will Be Challenging

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May 04, 2018

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

Foreign currencySwitching to the Secured Overnight Financing Rate (SOFR) should provide major benefits to corporates’ cash-management and funding efforts, and with the transition now taking its first steps, they should carefully monitor its progress to prepare for the change.

Rumblings about replacing the London interbank offered rate (Libor) began when scandals following the 2008 financial crisis revealed that some global banks profited by manipulating the inter-bank-borrowing-rate estimates used to calculate it. US regulators consequently sought a more transparent benchmark and settled on SOFR. However, the transition away from Libor, the reference rate for upwards of $350 trillion in derivatives and other financial products, is bound to face significant challenges.

In terms of transparency, SOFR is calculated from three existing indices directly related to overnight Treasury repurchase agreements (repos), noted Jose Vega, co-chief investment officer at South Street Securities, which specializes in securities finance.

“These transaction-based indices comprise many more participants in the capital markets community besides banks, including broker-dealers, asset managers, and a variety of other participants,” Mr. Vega said.

He said that satisfies the objective of the Alternative Reference Rates Committee (ARRC), which was convened by the Fed to provide market participants with transparent, actual transaction-based data, during the move away from Libor, which is based on theoretical rates submitted by a group of banks.

“It is this actual trading data that reinforces the credibility of the rate itself and accomplishes what the regulators were mandated to deliver for market transparency and robustness,” Mr. Vega said.

Since the Federal Reserve Bank of New York began publishing the reference rate April 2, the volume of transactions generating SOFR has hovered around $800 billion daily. The transparency that volume provides should benefit corporates now parking cash in money-market funds or similar short-term investment vehicles. Returns on those products are now typically measured against the opaque Libor index, and comparing them to SOFR will more clearly display whether they are competitive or not, and why.

“Treasurers now have access to market data when managing their cash, and SOFR should give them more flexibility in doing that,” Mr. Vega said. “Having this information and price transparency gives them information that was previously unavailable.”

Mr. Vega said one challenge to adopting SOFR will be transitioning existing Libor-based contracts. How market participants will do that remains unclear, since no financial tools have emerged yet to bridge the indices.

A second challenge is that SOFR is an overnight rate, with no term structure yet. Bank debt today is typically priced off three-month term Libor, enabling borrowers to know their interest payment ahead of time and allowing them to plan their cash flows accordingly. SOFR, instead, is a daily average or compounded rate, so borrowers won’t know the size of the interest payment until the end of the specific debt period.

This complicates the task of transitioning to SOFR and addressing mismatches between Libor-based legacy debt and SOFR-based hedges. “The question becomes whether bank lending desks will try to serve their corporate clients’ lending needs by providing term products,” said Eric Juzenas, director of global regulatory and compliance policy at Chatham Financial. “If banks were to do that, there might need to be additional risk management products, as well, such as SOFR term vs. SOFR overnight average swaps,” and swaps bridging the basis difference between Libor and SOFR, he added.

In fact, banks’ cooperation will be a key sign that a shift to SOFR is occurring, since today no such products exist. Another early signal will be the CME Group’s one- and three-month SOFR futures, scheduled to be launched May 7, and the support they receive from Wall Street players.

“We worked extensively with our clients to design SOFR futures, which in addition to our existing suite of interest-rate futures, will provide clients with new spread trading opportunities and tools that can be used for investment, risk management and hedging,” Agha Mirza, global head of interest-rate products at CME, said in a statement.

Mr. Vega noted that there is a precedent for developing a futures market around a new financial index. In 2012, the Intercontinental Exchange (ICE) launched a futures market based on the DTCC GCF Repo Index that was designed to track the average daily interest rates paid for overnight general collateral finance (GCF) repurchase agreements on US Treasury, agency and mortgage-backed securities. Mr. Vega said open interest on the contracts started out strong but dropped after the first few years as regulatory changes impacted the cost of capital for market participants.

“A futures market needs sponsors--parties who will commit capital and provide liquidity,” Mr. Vega said. “This buy-in and adoption will be critical to making the new SOFR futures markets a viable alternative to Eurodollar futures.”

Mr. Vega added that corporates should look for at least a few bulge bracket banks stepping up to the plate as market makers.

New futures markets face a chicken-or-egg dilemma, given market makers may hesitate to take the plunge unless there is already sufficient liquidity to make it worth expending resources. Consequently, an extra push may be required.

Mr. Juzenas noted several potential forces pushing the transition to SOFR. Auditors may begin to express concern about the Libor benchmark fading and ask clients about plans to address the risk that Libor-based debt and derivatives will no longer exist. Corporate accountants and treasuries would then need to generate valuations for assets using SOFR, providing incentives to transition to the new rate. Banks may also limit their issuance of new debt or derivatives based on Libor, pushing corporates and other market participants to look for new instruments to value and hedge SOFR-based products. A third possibility may involve bank regulators, the instigators of the push away from Libor, pressuring banks to lower exposure to Libor.

But a lot has to happen before SOFR is used to price the myriad products that today use Libor. As corporates wait for those products and other signs the market is shifting, they should determine their exposure to Libor-based products and analyze their fallback provisions, since at a certain point in the transition the Libor benchmark may become unavailable. Mr. Juzenas noted that the International Swap Dealers Association (ISDA) and other industry trade groups are now seeking to develop standard fallback language, but corporates are likely to have Libor-based products already in place for which the varying fallback language may present some risks.

“They want to make sure there’s no unintended value transfer should Libor become unavailable and they have to transition to SOFR,” Mr. Juzenas said. “They have to be able to transition to whatever the alternative rate is, while still ensuring the economics and effectiveness of the original loan and hedge.”

European corporates have been active users of the repurchase agreement market there, but their US counterparts have been less enthusiastic. The introduction of SOFR may change that.

“Corporate treasurers now have a lens into the repo market. This money market investment option can now be viewed with greater confidence, given the transparency and liquidity of the SOFR index and SOFR futures market,” Mr. Vega said.

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