The Federal Reserve Bank of New York recently commenced publication of a new short-term rate benchmark. The Secured Overnight Funding Rate (SOFR) is intended to replace Libor as the new standard for pricing short-term floating rate debt and serve as a reference rate for a new futures and derivatives market.
Following scandals related to the manipulation of Libor, the Fed established the Alternative Reference Rates Committee (ARRC) in 2014 to identify and establish a new reference rate, and to develop an adoption and implementation plan with a timeline and measures of market acceptance.
Such a new measure is needed to provide a more realistic measure of the short-term cost of funds. Libor is based on a survey of rates that large banks charge each other for interbank loans. As the short-term interbank lending market has shrunk in recent years, the bank’s estimates are often based on “hypothetical” charges and not actual trades. According to the St. Louis Fed, the interbank lending market has shrunk from close to $500 billion in 2008 to $80 billion today.
The ARRC’s intention was to provide a reference rate that is based on actual trades from a large, liquid short-term borrowing market. The Committee selected components of the Treasury repurchase agreement (repo) market. The SOFR therefore reflects a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. By reporting rates based on such trades, the committee intended to establish a measure of short-term lending based on “risk-free” debt.
Without getting too deep into the technical details, SOFR consists of three different types transactions: of tri-party repo data collected from BNY Mellon, the GCF repo transaction data, and bi-lateral trades cleared through the Fixed Income Clearing Corporation (FICC). Together, these sources account for roughly $800 – $850 billion of daily transaction volume. The Fed publishes two additional rates that reflect broad transactions in the repo market.
Despite cautioning from the UK Financial Conduct Authority that Libor may not be available after 2021, it appears that it Libor may not actually go away very soon. According to an ARRC report released in March, there is an astounding $200 trillion of notional volume in derivatives and financial products tied to US dollar Libor. The unwinding this large volume of derivatives, especially for longer dated interest rate swaps will take some time. Many analysts believe that either fallback provisions will be amended in transaction documents to provide a SOFR alternative in the event that Libor becomes unavailable, or a smaller group banks on the Libor panel will continue to provide Libor quotations for some time into the future.
In response, the AARC has established a “Paced Transition Plan”, which outlines a path toward the establishment of a forward-looking term rate based on SOFR derivatives markets, along with other measures to mitigate Libor risk. In a presentation to the ARRC last year, Fed Chairman Jerome Powell noted that the sudden cessation of a benchmark as widely used as Libor could pose significant systemic risks.
The CME is expected to begin trading in monthly and weekly futures based on the SOFR rates shortly, while later this year it is expected to launch trading in interest rate swaps that are tied to the SOFR rate.
There appear to be many benefits to establishing the new benchmark based on SOFR, including improved market transparency and oversight from the Fed. However, the implementation of the SOFR rate is not without its detractors. One key concern is the potential withdrawl of liquidity from the repo market in times of financial distress, and the fact that a Treasury-based rate could stray from the true costs of commercial lending.
So, what exactly is the new SOFR rate, you may ask? According to the New York Fed the SOFR closed on Wednesday, April 18th at 1.75%, while one-month Libor closed at 1.89%.
By Mark Gallagher, Senior Strategist, Americas Research – Investment Consulting, CBRE.