PRIMER: the Secured Overnight Financing Rate (SOFR)
IFLR's latest primer looks in depth at the most likely long-term replacement for the Libor benchmark interest rate
What is SOFR?
The secured overnight financing rate (SOFR) is a new lending reference rate established by the Federal Reserve Bank of New York. It sets the benchmark interest rate of the cost of borrowing cash overnight as collateralised by US Treasury securities. Although still in its infancy, US regulators anticipate that the rate will be widely adopted to back the derivatives and loans market, and is widely expected to be the universally accepted replacement for the outgoing London interbank offered rate (Libor), which expires at the end of 2021.
How is the rate calculated?
"It transpired during the financial crisis that multiple banks had been manipulating the Libor price for several years, which led to hefty fines, multiple court cases and imprisonment for UBS trader Tom Hayes"
The way SOFR is calculated incorporates all of the trades in the Broad General Collateral Rate (BGRC), another rate that measures overnight Treasury collateral transactions, as well as bilateral Treasury repurchase agreement (repo) transactions that are cleared through the delivery-versus-payment (DVP) service offered by the Fixed Income Clearing Corporation (FICC). The New York Fed’s website states that SOFR is calculated as a volume-weighted median of transaction-level tri-party repo data collected from the Bank of New York Mellon as well as GCF Repo transaction data and data on bilateral Treasury repo transactions cleared through FICC's DVP service, which are obtained from DTCC Solutions, an affiliate of the Depository Trust & Clearing Corporation'.
This is the rate that banks will pay on the repo market for borrowing overnight. The New York Fed publishes the SOFR rate on its website at around 8am every morning.
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Who came up with this?
The rate was established by the Alternative Reference Rate Committee (ARRC), which was appointed by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York in 2014, in response to growing concerns that existing rates were insufficient for the needs of the market.
ARCC was tasked with identifying best practices for alternative reference rates, like SOFR , as well as finding best practices for contract robustness, developing adoption and implementation plans that include metrics of success.
The ARCC published its Paced Transition Plan as part of its second report in March 2018. The plan addressed the specific challenges that the transition to SOFR will pose, the first of which is in establishing sufficient liquidity for derivatives contracts that use the rate – as traders will not be able to, or be expected, to make the transition otherwise.
“The ARRC’s Paced Transition Plan is intended to progressively build the liquidity required to support the issuance of and transition to contracts referencing SOFR , and to create conditions in which a robust term reference rate based on derivatives referencing SOFR could be constructed and itself used in some cash products,” reads the report.
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What's wrong with Libor?
The Libor rate is the existing rate that is widely used around the world. It is an average of the interest rates that London’s leading banks would be charged if they were to borrow from other institutions. Currently it stands as the first port of call for calculating interest rates, offering overnight maturities as well as terms of one week and one, two, three, six and 12 months. It is calculated in five currencies.
There are a number of reasons for the market shift away from Libor. A scarcity in actual underlying transactions has meant that the market needed to find an alternative. On top of this, it transpired during the financial crisis that multiple banks had been manipulating the Libor price for several years, which led to hefty fines, multiple court cases and imprisonment for UBS trader Tom Hayes.
This was followed by altercations in how the rate was set, but the damage had been done and banks began to distance themselves from the rate and contributed submissions less often. The UK Financial Conduct Authority (FCA) announced plans to phase out the rate by the end of 2021 and banks will no longer be required to submit daily dates used in its calculation, which may result in its demise.
JP Morgan Chase’s chief regulatory affairs and chair of the Federal Reserve Board Alternative Reference Rates Committee officer Sandie O’Connor told the PwC and the Securities Industry and Financial Markets Association’s (Sifma) Libor symposium in June that the existing Libor rate is no longer fit for purpose, and the industry must prepare for its eventual decline and formulate durable fall-back language.
“If you think about financial benchmarks, not just Libor, but any financial benchmarks, they are fundamental to functioning markets,” she said. “It is essential that they maintain integrity so that instruments and products around the globe can have a common linkage.”
Libor does not meet the criteria that an adequate benchmark must: transaction based and transparent with appropriate levels of governance. The reference rate no longer has a high level of transactions, averaging just $1 billion of trades per a day, with that number often closer to $500 million. By way of comparison, the entire market is estimated to be worth in the region of $200 trillion.
"Some $750 billion in daily volume makes SOFR the deepest, highest volume rates market in the world, bar none. A true benchmark didn’t exist until April 3"
This is an enormous inverted triangle of activity, meaning that Libor is based on hypothetical transactions or judgement, an awful lot of activity tied to a very small number of actual transactions.
“SOFR is the most critical deliverable of ARCC 1.0. We all talk about why we have got to be prepared for when Libor ends, but think about the Soft rate, on average it is $750 billion of daily volume, a lot more than $1 billion,” said O’Connor.
“Some $750 billion in daily volume makes SOFR the deepest, highest volume rates market in the world, bar none. A true benchmark didn’t exist until April 3. It is not just that we are going away from something, we are going towards something that is really good.”
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What are SOFR futures?
As the end of Libor approaches, one of the challenges is to find a rate that is not Libor but in fact is based upon a much larger volume of market transactions that can be said to really affect market rates. This would be a rate not just based on judgement. There are alternatives, like the Bank of England backed Sonia rate, but SOFR is the frontrunner.
“The dynamic and the fundamentals look good,” said O’Connor. “But one sector or segment cannot do this alone, we all have a collective interest - because we are trying to prepare a new market for the eventuality of the ongoing decline of Libor - so our organisations need to be moving forward to implement and begin referencing transactions.”
In June, Chicago-based derivatives and futures exchange CME launched SOFR futures as part of the transition away from Libor.
“The evolution of a liquid futures market is an important milestone of the ARRC paced transition plan. Clients have indicated that SOFR futures will have immediate investing, risk management, and hedging applications for repo and relative value traders,” Agha Mirza, managing director, interest rate products at CME Group told IFLR.
Over 7,000 CME SOFR futures contracts traded in the first week (listed May 7), and there are quarterly and seven monthly contracts. The quarterlies will help provide building blocks for the IRS market, whereas the monthlies offer greater granularity at the front end of the curve, especially as the nearest quarterly contract becomes more set through its reference quarter.
The liquidity generated in Globex through inter-commodity spreads and implied pricing functionality has the potential to combine with these initial applications to create a deep and liquid SOFR derivatives market over time that may have wider interest rate benchmark applications, added Mirza.
Introducing futures is a solution to how SOFR overnight secured rates can be evolved into something that would be more useful for the existing markets that rely upon term periods in Libor.
“The goal is to take an overnight rate and turn it into term periods. For example, if the overnight SOFR rate is x, what would the rate be if you were talking about a 3-month SOFR rate? That is something that is best determined again through trading activity,” said Lary Stromfeld, partner at Cadwalader. “You need a futures market that can determine what the market believes a 3-month SOFR rate would be relative to the overnight rate, and that is what this is.”
“It begins to address one of the structural elements that needs to develop to make the secured overnight rate into something that is more of a term period,” he added.
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What are SOFR securities?
Additionally, in summer 2018 there have been several issuances of SOFR backed securities, also instruments created to help develop the market. Three bonds linked to the index have launched so far. The first, a $6 billion floating rate note July 26 issuance by Fannie Mae, which broke ground amid hope that it would encourage a broader acceptance of securities indexed to SOFR . It was swiftly followed by issuances from the World Bank and Credit Suisse.
A spokesperson for Fannie Mae told IFLR that investors and dealers have already expedited operational readiness for SOFR bonds.
“The issuance helped to demonstrate market interest in SOFR based debt instruments. As a result, there are already illustrations of the transaction accelerating the development of the SOFR market, including: on July 30, Standard and Poor’s recognised SOFR as an anchor money market reference rate, which helps rated money market funds invest in SOFR based instruments.”
From a market development point, the more investors and issuers involved in this market, the more traction SOFR gets. As the market gains traction, and the more investors that are set up to transact in SOFR -linked products, the better for the development of the market.
“It is positive that these investors have done the work to get themselves set up, that they want to look at and get involved in this market,” said Greg Moore, head of US fixed income at TD Bank, who acted as lead manager on both the Fannie Mae and World Bank transactions. “It’s going to be a long, long process before the world is done with Libor, but the more institutions that are looking at SOFR , and thinking more in SOFR terms, be it issuers or investors, that is a positive for the development and adoption of SOFR ."
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DEAL: Fannie Mae's SOFR-linked bond