By John Hintze
SOFR rollout makes progress toward addressing cash products.
The 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 instruments referencing SOFR.
CME-listed, three-month SOFR futures contacts (SFR) 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 recently issued SOFR bonds. Toyota Motor Credit Corp. (TMCC) appears to be the first corporate to do so, issuing $500 million in three-month commercial paper priced off SOFR on Oct. 25.
As the largest nonbank direct US commercial paper program issuer, TMCC felt it was important to be involved early on, Nicholas Ro, treasury national manager of sales and trading for Toyota Financial Services, said 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, a committee governed by federal statute and consisting of members of investment funds and banks, has suggested that the Treasury look into offering debt instruments referencing SOFR.
“It’s my understanding that such a 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 upward 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 a term version 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 SOFR and a benchmark rate for hedge accounting.