With Formal Committee Support, Transition to SOFR in 'Homestretch'

The Alternative Reference Rates Committee (ARRC) has recommended a term version of the Secured Overnight Financing Rate (SOFR) for business loans and related transactions, after indicating previously that use of the term version should be much more limited. The move may deflate support for other London Interbank Offered Rate (Libor) alternatives.

The ARRC on July 21 recommended loan conventions and best practices to use a forward-looking SOFR term rate “across financial markets, including the use of the SOFR Term Rates for business loans.” The intent is to accelerate the transition away from Libor. Tom Wipf, ARRC chairman and vice chairman of institutional securities at Morgan Stanley, said in the statement that “market participants now have the tools and necessary guidance to support use of the SOFR term rate.”

The recommendation became formal on July 29, with Wipf calling it “an achievement for the USD Libor transition specifically and for financial stability overall. This concludes the ARRC's Paced Transition Plan and market participants now have all the tools they need as we enter the transition's homestretch.”

“With this step, market participants now have every tool they need to transition from Libor,” said Randal K. Quarles, Federal Reserve vice chair for supervision and chair of the Financial Stability Board. “All firms should be moving quickly to meet our supervisory guidance advising them to end new use of Libor this year.”

The ARRC, which has Federal Reserve sponsorship and participation of a wide range of financial market players, is not a regulatory body, but its recommendations carry significant weight.

A SOFR term rate recommendation had been expected following approval April 20 of key principles for forward-looking term SOFR. On the next day, CME Group said it would make available one-, three- and six-month term SOFR reference rates adhering to those principles. However, statements by ARRC officials caused concerns that its recommendation would limit the use of SOFR term rates to transactions that require terms, such as trade finance.

“Important Milestone”

“This may be a game changer,” said Meredith Coffey, executive vice president and co-head of public policy at the Loan Syndications & Trading Association (LSTA). “A term SOFR should soon be available for use by syndicated and bilateral business loans, hedges for business loans, and securitizations that reference those loans.”

Sean Tully, CME Group global head of financial and OTC products, said in a July 29 statement: "The ARRC's formal recommendation of CME Term SOFR Reference Rates is an important milestone for the industry and the continued development of the broader SOFR ecosystem. Today's decision provides the market with greater clarity and ensures CME Term SOFR Reference Rates are widely available for use alongside other forms of SOFR."

CME, which introduced SOFR futures three years ago, said second-quarter 2021 average daily contract volume of 118,000 was up 200% year-over-year, with a single-day record of 342,000 on June 18. Open interest was up 122%, to 828,000 contracts, with a record 858,000 contracts open on July 1.

Market Pressure

The ARRC's recommendation of a broad scope for term SOFR may stem from mounting pressure to accelerate the transition. For example, the Association for Financial Professionals, National Association of Corporate Treasurers, and U.S. Chamber of Commerce Center for Capital Markets Competitiveness, in a joint letter to financial regulators, detailed complications that nonfinancial corporations face, accentuated by a lack of transparency about the mechanics of the switch.

The letter said that in a survey of Nonfinancial Corporates [NFCs] Working Group members, “fully two-thirds have been unable to receive detailed proposals or timelines for implementation from their bankers.” Also, “by the time the banks have fully prepared transition materials and processes, the NFCs awaiting that information would have little to no time to rework contracts and internal compliance and technology systems,” even by the June 2023 deadline to transition all existing transactions.

“The implicit message was, “We need you to pressure banks to educate customers and staring moving this along,'” said J. Paul Forrester, a partner at Mayer Brown.

All new floating-rate transactions must use a Libor replacement by the start of next year. So far, however, mostly financial institutions have tested the waters, and issuance of debt priced over the replacement rates has been light, although Ford Motor Co. announced in early July its intent to refinance over SOFR all of its credit facilities, totaling $15.4 billion.

Hesitancy to transition to SOFR has been attributed in part to the lack of a forward-looking term rate. Borrowers in the cash markets would otherwise have to calculate interest payments using daily SOFR, a more complicated approach operationally that misses out on the cash-forecasting benefit of knowing at the start of a term what those payments will be. That shortcoming generated interest in Libor alternatives with term rates, including the Bloomberg Short-Term Bank Yield (BSBY) index and the American Financial Exchange's (AFX) Ameribor.

Regulator Preference

Coffey said that the credit-sensitive rates' incorporation of terms and sensitivity to bank credit risk - elements that daily SOFR lacks - fueled interest in them, but the introduction of a term SOFR may change that.

“Those entities looking to BSBY because they wanted to have a term rate now have a term SOFR, a rate that regulators prefer,” the LSTA official said. “However, to the extent that a party wants a credit-sensitive rate, then [one] such as BSBY is of course relevant.”

Coffey added that borrowers generally might prefer a risk-free rate such as SOFR, which in periods of market stress tends to remain flat or tighten. Regional and community banks, on the other hand, fund their activities in markets such as commercial paper (CP), certificates of deposit (CDs) and short-term bonds. The rates on those products typically increase during stressful periods, potentially resulting in mismatched assets and liabilities.

American Financial Exchange, primarily serving regional and smaller banks, has been vocal in advocating freedom of choice among multiple benchmarks. AFX director and former Commodity Futures Trading Commission chairman J. Christopher Giancarlo wrote recently in American Banker that Congress should “make clear that for new benchmark-linked contracts in a post-Libor age, institutions and their customers will face no restriction in choosing among qualified market-based benchmarks that properly align local and community lending institutions and their cost of funding.”

“Inverted Pyramid Problem”

Federal Reserve Chair Jerome Powell has indicated support for credit-sensitive Libor-replacement rates, if the market demonstrates a need for them.

By contrast, in a June 11 public statement, Securities and Exchange Commission Chairman Gary Gensler said BSBY, and by extension other credit-sensitive alternatives, have the “same flaws as Libor,” since they are based on unsecured, term, bank-to-bank lending. BSBY, he said, has the same “inverted pyramid problem” as Libor, as the reference rate generated from transaction volume averaging in the low double-digit billions of dollars is designed to support trillions of dollars in financial products.

That mismatch, he added, can result in manipulation, and the bank funding markets used to generate the credit-sensitive rates may dry up in times of market stress.

The Federal Housing Finance Agency, one of the largest issuers of SOFR-based notes, echoed Gensler's critique in a July 1 letter to Federal Home Loan Bank presidents and chief executive officers. It warned that credit-sensitive alternatives could “destabilize a smooth functioning market and overall economic conditions.”

Alexey Surkov, a partner with Deloitte Risk and Financial Advisory and a co-chair of the ARRC Operations/Infrastructure Working Group, said that replacement rates sharing Libor's issues raises questions about whether to adopt them.

“If we're going through this massive transformation, it must be worth it in the end,” Surkov said, adding the ARRC's recommendation of SOFR was based on the Treasury repo market that underlies the benchmark and totals upwards of $1 trillion in daily volume.

The volume of transactions used to generate BSBY and other credit-sensitive rates may be much higher than the $500 million to $1 billion in quotes from 16 banks used to calculate Libor. It nevertheless pales next to the $200 trillion in floating-rate transactions that the replacement rates must support, raising concerns that they are insufficiently robust.

That comparison may be misleading, however, since $190 trillion of those transactions are derivatives, and the credit-sensitive rates are aimed at approximately $10 trillion in cash and cash-related products.

“In the post-Libor world, the vast majority of those derivatives should be SOFR-based, and that should mitigate the inverted pyramid problem,” Coffey said.

Vulnerable to Manipulation?

Coffey questioned whether, like Libor, the credit-sensitive rates can be easily manipulated. She noted that rather than relying on Libor's 16 banks to submit quotes reflecting the rates observed in the funding markets, Bloomberg generates BSBY directly from transactions in those same markets.

“Bloomberg is seeing actual transactions,” Coffey said. “To move BSBY, a party likely would have to make an off-market trade and would face a profit or loss from that.”

Bloomberg uses funding-market trades from 34 large U.S. banks. It noted in a white paper several “built-in protections against manipulation” that include capping the weight of each transaction to $500 million and imposing a single-issuer cap of 20% to ensure a broad sample of banks.

In terms of liquidity, a July 8 Bank Policy Institute (BPI) paper by CEO Greg Baer provided support for BSBY and by extension other credit-sensitive rates referencing the same bank funding markets. He said the CP market is approximately $1.2 trillion in size and averaged $82 billion daily between January 2018 and February 2021, with financial institutions doing nearly 60% of those transactions. The institutional CD market has averaged $11.3 billion in daily issuance over the last few years.

If volumes fail to meet the specified minimums for each of BSBY's different terms, then rolling windows of previous days' data are used to meet the necessary thresholds to generate the rates. If insufficient volumes persist, the previous business day's rate is carried over and thus is essentially fixed. Should Bloomberg decide to stop publishing BSBY, banks' fallback language transitions the instrument to a fallback rate based on SOFR plus a spread. The other credit-sensitive rates take a similar approach.

Baer said the FHFA criticizes such processes in general terms, including the use of executable quotes as proxies for actual transactions. But CME is reportedly using a methodology developed by the Federal Reserve that uses executable quotes along with actual transactions to generate term SOFR, “and it seems unlikely that the FHFA is seeking to discourage use of term SOFR,” Baer added.

The BPI analysis concluded that “BSBY does not appear to be subject to manipulation or present a financial stability risk, but if government agencies believe that it or some other reference rate is fatally flawed, then the appropriate process for taking such action is a regulatory one, with prior notice and public comment by the affected parties . . . not a non-public process using examiners to direct individual firms to avoid that benchmark.”