The Federal Reserve Bank of New York (FRBNY) recently unveiled the publication of three reference rates: the Secured Overnight Financing Rate (SOFR), the Tri-Party General Collateral Rate (TGCR) and the Broad General Collateral Rate (BGCR). The production of the three reference rates signaled the start of the phased transition by the Fed away from the London Interbank Offered Rate (LIBOR) to a new paradigm. This dramatic shift is part of a multi-year effort by regulators to restore market confidence and transparency in the wake of the LIBOR rigging scandal that rocked the global markets.
SOFR was first recommended as the US dollar alternative to the LIBOR back in June 2017 by the Alternative Reference Rates Committee (ARRC) – a committee comprised of board of governors of the Federal Reserve (“the Fed”), the FRBNY, financial institutions, trade groups and other regulators. The election of SOFR is the culmination of work begun by the Fed and the US Treasury Office of Financial Research (OFR) in 2014, when the ARRC was convened to create a new set of alternative reference rates rooted in actual transactions.
TGCR, BGCR and SOFR reflect transactions in the Treasury repurchase market. TGCR is a measure of rates on overnight counterparty/tri-party general collateral repurchase agreement (repo) transactions secured by Treasury securities, while BGCR measures rates on overnight Treasury general collateral repo transactions. The BGCR includes all trades used in the TGCR, as well as general collateral financing (GCF) repo trades. Of the three reference rates, SOFR was deemed to be the best alternative to LIBOR.
SOFR’s daily volume (which the FBRNY estimated at $800 billion, for underlying transactions, in November 2017) and coverage across multiple repo market segments allow for flexibility for future market evolution.
The death of LIBOR appears to be a foregone conclusion. Andrew Bailey, CEO of the UK’s Financial Conduct Authority (FCA), has minced no words in confirming the planned LIBOR phase-out after 2021. “While we have given our full support to encouraging panel banks to continue to contribute and maintaining LIBOR over recent years, we do not think markets can rely on LIBOR continuing to be available indefinitely,” he said in a July 2017 speech on the future of LIBOR.
For better or worse, the switchover to SOFR is inevitable – but also complicated. One fundamental challenge on SOFR’s suitability for lending arrangements is that SOFR reflects an overnight risk-free rate based on secured transactions, with Treasuries as collateral. LIBOR, in contrast, provides a term rate with different tenors on an unsecured basis.
LIBOR has largely been a proxy for banks’ cost of funds. This difference limits SOFR as a benchmark for unsecured term transactions with longer tenors that carry higher borrowing costs. To resolve what could be a problematic difference between SOFR and LIBOR, market participants have called for a dynamic credit spread to be incorporated into SOFR.
Although ARRC has announced the eventual creation of a SOFR term reference rate, that move will largely depend on the speed on establishing liquidity for SOFR-based products. The CME Group, which launched SOFR futures earlier, is leading the charge. Major swap dealers, meanwhile, are expected to start trading SOFR-based products later this year.
The logistics of tracking an overnight rate versus monthly rates may prove daunting for many market participants requiring systems upgrades and infrastructure realignments. Regulators and market utilities will likewise need to jump on the bandwagon and adapt to new technology requirements. Investors, moreover, will need to adjust to daily and intramonthly volatility considerations for the repo market.
Executing the ARRC plan poses serious challenges, particularly given the reported $200 trillion worth of financial contracts referencing USD LIBOR. Indeed, the development of contract language for fallback provisions in derivatives contracts that go beyond 2021 ranks as top priority.
In an April 2018 report, BlackRock estimates total gross notional USD LIBOR exposure of $35.8 trillion in 2021, $15. 9 trillion in 2025 and $8.0 trillion beyond 2030. Keeping these numbers in mind, the International Swap Dealers Association (ISDA) has convened various working groups to address risks and create practical solutions to remediate contracts post-LIBOR.
Despite ISDA and overall efforts by regulators, firms individually need to prepare for contract amendments to legacy contracts individually. Fed Chair Jerome Powell underscored the problem in his November 2017 address to the ARRC. “The most complicated aspects involve the legacy contracts that reference LIBOR, many of which do not have strong language in place if LIBOR were to stop publication,” he cautioned.
A clear accounting of a firm’s exposures by asset class (e.g., derivatives, loans, bonds) within their portfolios need to be determined, focusing on accounting, valuation and tax considerations. What’s more, investments in technology will be necessary to adapt to new operational processing changes.
For LIBOR reform to be truly successful, liquidity for SOFR based products will be key to broad market adoption. Taking this into account, the ARRC has mapped out a “Paced Transition Plan” that intends to introduce and grow the demand for SOFR derivatives. Moreover, the ARRC likewise intends to develop a forward-looking term rate based on SOFR derivatives markets. With LIBOR all but dead, SOFR is not just the new game in town but the only game in town.
More about SOFR: https://apps.newyorkfed.org/markets/autorates/sofr
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