What is SOFR, and Why is it Replacing LIBOR?
(October 20, 2020) – The Secured Overnight Financing Rate (SOFR) is a reference rate that determines pay-offs in a financial contract and that is outside the control of parties to the contract. So is the London Inter-bank Offered Rate (LIBOR). However, in the United States, SOFR is fast becoming a key financial benchmark that will soon replace U.S. dollar LIBOR. The transition from a reference rate system centered on interbank offered rates to one based on a new set of overnight risk-free rates is an important shift for markets.
SOFR versus LIBOR: Key Differences
SOFR and LIBOR both reflect short-term borrowing costs, but with key differences. First, SOFR is a “near risk-free rate” based on transaction data underlying multiple segments of repurchase (repos) agreements secured by U.S. Treasuries. LIBOR, meanwhile, is an interest-rate average, based on unsecured transactions, calculated from “expert judgement” estimates submitted by the leading banks in London and priced to include bank funding risk. Secondly, SOFR is an overnight rate closely correlating with other money market rates, while LIBOR, based on five currencies including the U.S. dollar, the euro, the British pound, the Japanese yen, and the Swiss franc, publishes seven varying rates of one day to one year. Lastly, LIBOR was launched in 1986 by the British Bankers’ Association. SOFR was introduced by the U.S. Federal Reserve in 2017 and first published in 2018.
However, in June 2017, the Federal Reserve announced that it preferred SOFR over LIBOR in certain new U.S. dollar denominated loans and securities. Conversely, LIBOR’s UK regulator announced that after 2021 it will no longer compel banks to submit rates needed to publish the benchmark.
How we reached this point, and what issues face investors during the transition to SOFR from LIBOR, is discussed below.
2012: The LIBOR Scandal
In June of 2012, in a settlement with U.S. and U.K. regulators, Barclays PLC was fined $450 million after admitting it had manipulated LIBOR to gain profits and/o /limit losses from derivatives trades. In addition, Barclays admitted it made dishonestly low LIBOR submission rates from 2007-2009 to dampen market speculation and negative media comments about the firm’s viability during the financial crisis.
In August, a joint New York-Connecticut investigation of LIBOR issues subpoenas to Royal Bank of Scotland, HSBC Holdings, JPMorgan, Deutsche Bank, Barclays, UBS and Citigroup, seeking evidence of possible collusion that may have played a role in alleged rate manipulation. Evidence provided by emails and phone records showed traders openly asking others to set rates at a specific amount so that a position would be profitable. Regulators in both the United States and the United Kingdom eventually levy nearly $9 billion in fines on banks involved in the scandal, as well as file numerous criminal charges. Because LIBOR is used in the pricing of many of the financial instruments used by corporations and governments around the world, they, too, file lawsuits, alleging that the rate-rigging negatively affected them.
On September 28, Britain’s Financial Conduct Authority (FCA) announced a 10-point plan to overhaul LIBOR, including taking responsibility for LIBOR supervision away from the British Bankers Association (BBA) and turning it over to the ICE Benchmark Administration (IBA).
2014: The Alternative Reference Rates Committee (ARRC)
In a report published by the Federal Reserve in 2014, it was estimated that, as of 2012, U.S. dollar contracts referencing LIBOR totaled $160 trillion in gross notional exposure, roughly equivalent to ten times U.S. GDP. Of that amount, 95% were tied to derivative market accounts. These LIBOR exposures dwarfed the volumes underlying the wholesale unsecured term bank funding markets that LIBOR was meant to represent. For example, the median daily volume of three-month funding transactions (the most heavily referenced tenor of LIBOR) was less than $1 billion, and there were many days with volumes of less than $500 million. Furthermore, the number of banks submitting to LIBOR was only about half of GSIBs (global systemically important banks), so the actual volumes underlying LIBOR were likely to be about half of those reported.
Consequently, while significant progress had been made in strengthening the governance and processes underlying LIBOR, it was determined by the Federal Reserve that a precipitous decline in wholesale unsecured term money market funding by banks posed serious structural risk for unsecured benchmarks such as LIBOR. Because LIBOR was used in such a large volume of broad range of financial products and contracts, the risks surrounding it posed a potential threat to the safety and soundness of individual financial institutions and to financial stability.
To address these risks, the Federal Reserve and the New York Fed convened in 2014 the Alternative Reference Rates Committee (ARRC), a group of private-market participants. The ARRC’s initial objectives were to identify risk-free alternative reference rates to LIBOR, identify best practices for contract robustness, and create an implementation plan with metrics of success and a timeline to support an orderly adoption.
2017-2018: The Rise of SOFR and the Fall of LIBOR
The ARRC held its first meeting in December 2014 and met regularly to work towards its objectives. The ARRC considered a comprehensive list of potential alternatives, including other term unsecured rates, overnight unsecured rates such as the effective fed funds rate (EFFR) and overnight bank funding rate (OBFR), secured repo rates, Treasury bill and bond rates, and overnight index swap (OIS) rates linked to EFFR. After extensive discussion, the ARRC preliminarily narrowed this list down to two types of rates that it considered to be the strongest potential alternatives: an overnight unsecured rate (the OBFR) and some form of overnight Treasury repo rate (SOFR). The ARRC discussed the merits of and sought feedback on both rates.
On June 22, 2017, the ARRC identified SOFR as the rate that represents best practice for use in certain new U.S. dollar derivatives and other financial contracts. According to the Federal Reserve, SOFR had the widest coverage of any Treasury repo rate available, with transactions underlying SOFR regularly exceeding $700 billion in daily transactions in 2016, representing the largest rates market of any given tenor in the U.S. In a statement, the Federal Reserve stated, “The volumes underlying SOFR are far larger than the transactions in any other U.S. money market and dwarf the volumes underlying LIBOR or other term unsecured funding rates. Because of its range of coverage, SOFR is a good representation of general funding conditions in the overnight Treasury repo market. As such, it will reflect an economic cost of lending and borrowing relevant to the wide array of market participants active in these markets, including not only broker-dealers, but also money market funds, asset managers, insurance companies, securities lenders, and pension funds.”
On June 27, 2017, in a speech delivered in London, Andrew Bailey, Chief Executive of the Financial Conduct Committee, announced that the U.K. regulatory organization will support LIBOR only until the end of 2021. After that, the FCA would not compel banks to submit rates needed to publish the benchmark.
2018-Present: Transition to SOFR
On April 3, 2018, the New York Fed began publishing daily the SOFR. However, given the structural differences between LIBOR and SOFR, LIBOR couldn’t simply be “swapped out” with SOFR in existing contracts that reference LIBOR. To account for the differences during the transition, regulators encouraged institutions to include “fallback” clauses in all new contracts, outlining exactly how differences between SOFR and LIBOR would be calculated. For example, to address the challenge posed by the stock of existing derivatives, the largest component of the LIBOR footprint, the International Swaps and Dealers Association is at work developing fallback language that dealers and customers could adopt voluntarily. In addition, the ARRC has recommended fallback language for business loans, floating rate notes, adjustable rate mortgages, and securitizations.
The smooth transition to SOFR is also dependent upon the development of strong, deep, and liquid markets for SOFR futures and swaps. The first exchange to begin facilitating trading of SOFR futures was the CME Group in May 2018. CME provides trading of one-month SOFR (SR1) and three-month (SR3) futures. SOFR is the fourth best launch of a CME product in the exchange’s 170+ year history, and market participants grew from 55 in the May 2018 launch to over 165 by mid-2019.
On the Rise: SOFR-based Bond Issuance
Fannie Mae issued the first-ever SOFR-based debt security in July 2019, a $6 billion, three-tranche transaction. By the end of 2018, a total of $36 billion worth of SOFR-based debt had been issued. SOFR issuance exploded in 2019, with $265 billion issued by September 30.
SOFR continued to gain traction into December. Freddie Mac priced approximately $765 million in SOFR-denominated K Certificates, its first multifamily real estate securitization with bonds indexed to SOFR, joining Fannie Mae in its efforts to move multifamily finance to a SOFR-based environment. MUFG Union Bank, N.A. closed a $1 billion bank note offering, which includes a tranche with a coupon tied to SOFR plus a spread of 71 basis points maturing in 2022. Similarly, Royal Dutch Shell PLC announced it has signed a $10 billion line of credit linked to SOFR, which replaces its $8.84 billion revolving credit facility.
A Prime Issue with SOFR: Volatility
Whereas SOFR meets a range of criteria that a robust benchmark must satisfy, including daily underlying SOFR transactions now routinely exceeding $1 trillion, the risk of market forces having an adverse impact on financing appear to be greater under SOFR. When it comes to SOFR, the relevant repo transactions specifically focus on borrowing cash overnight collateralized by Treasury securities. Thus, the supply and demand for both loanable cash and Treasury securities can fluctuate significantly on a day-to-day basis and drive movements in Treasury repo markets and hence SOFR. For example, SOFR shot up to 3.15% on January 2, 2019 from 2.46% on December 28, 2018 before quickly returning to previous levels. Reasons for this type of move include the fact that banks are less willing to lend in the repo market around month/quarter-end for regulatory reasons.
A similar yet more dramatic move in SOFR occurred on September 17, 2019. In a day referred to as the “SOFR Surge Event,” a confluence of several events exposed insufficient elasticity in the U.S. dollar overnight repo market, causing the overnight SOFR to increase by 282 basis points (to 5.25% from 2.43%) compared to the previous day. While considered just a one-time event, the SOFR Surge Event presented a material change for risk managers tasked with overseeing a complex book of interest rate positions, including banks needing to agree on rates with their counterparties.
Recent changes to U.S. monetary and fiscal policies have also fueled increases in volatility within the repo market. From 2008-2014, bank reserves maintained by the Federal Reserves mushroomed due to the quantitative easing (QE) measures the Fed undertook during the global financial crisis. But the Fed began unwinding its QE in October 2017 by allowing the Treasury and mortgage-backed securities it owned to slowly run off its balance sheet. The shrinkage on the asset side of the Fed’s balance sheet was met by a commensurate decline in the Fed’s liabilities, namely bank reserves, which receded by more than 50%, reaching a bottom in September 2019. On the Treasury collateral side of the equation, the primary driver of more Treasury securities has been the increase in the federal budget deficit. As recently as FY 2015, the budget deficit was $439 billion, whereas by FY 2019, which ended on September 30, 2019, saw a deficit of $984 billion, a more than 100% increase in just four years. Putting these two factors together, privately-held, marketable Treasuries outstanding have risen roughly $2.4 trillion over the past two years, causing the ratio of Treasury securities outstanding to bank reserves to double in early 2018 from roughly 5.0 to approximately 10.0 in September 2019, only to subsequently decline as the Fed bought Treasury bills to add reserves to the financial system.
SOFR: What Happens if Repo Rates Go Negative?
Various interest rates around the globe, especially in Europe, have turned negative, driven by the exceptional lending practices extended by the ECB and other European central banks in an attempt to spur growth and head off deflation. A negative repo rate implies that the buyer (who is lending cash) effectively pays interest to the seller (who is borrowing cash). Negative repo rates can happen when a collateral security is subject to exceptional borrowing demand and/or reduced supply in the repo market. In order to borrow these securities, buyers must tempt potential sellers with “cheap” cash. In Europe, this meant that most, if not all, securities in a currency were subject to exceptional demand. Typically, these securities were government bonds of strong economies and were sought after because they were seen as “safe haven” assets. Given the present low level of U.S. interest rates and the perceived “safe haven” of Treasury securities, repo rates in the United States could fall below zero.
In the event SOFR becomes negative, the ARRC has recommended that floating-rate notes (FRN) referenced to SOFR will be floored to zero, primarily because systems have not been developed to handle a coupon payment from an investor to an issuer.
SOFR provides a robust and credible overnight reference rate, well-suited for many purposes and market needs. In the future, U.S. dollar cash and derivatives are expected to migrate to SOFR as a main set of benchmarks. To manage asset-liability risk, financial intermediaries may continue to need a set of benchmarks that provide a close match to their marginal funding needs. This may call for other risk-free rates to be complemented with some form of credit-sensitive benchmark. Ultimately, it is possible that several different benchmark formats will coexist, fulfilling a variety of purposes and market needs.
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