Let’s Talk About SOFR

Moving from LIBOR to SOFR

In 2017, the U.S. Alternative Reference Rates Committee (ARRC) announced their choice of the secured overnight financing rate (SOFR) as their preferred rate to replace LIBOR in response to the manipulation of LIBOR during the financial crisis, which resulted in billions of dollars in fines and related enforcement actions and decline in confidence in LIBOR rate setting. Since then, ARRC has been working to fully define SOFR and assist banks in defining the timeline for the replacement, with the goal of fully phasing out LIBOR by the end of 2021. But how is that going, and do we fully understand how SOFR will work?

SOFR was designed to be more reliable than LIBOR and impervious to manipulation because it is based on actual rates in short-term cash markets. LIBOR, by contrast, is an “indicative rate” based on the rates banks say they can get. But the path forward isn’t clear, and the guarantee that SOFR will be the panacea hope for by its proponents has wobbled a bit with market turmoil in the past year, especially in the market for Treasury repurchase agreements (“Repos”). A shortage of available cash caused rates to spike in this obscure but crucial part of financial system, with rates climbing as high as 10% from around 2%, pushing SOFR to a record 5.25%, about 3 percentage points above its previous range.

In combination with actual market indications, there is also the issue that the AARC hasn’t finalized its definition/guidance on one of the four SOFR rate methods. SOFR Compounded in Arrears mathematics is still under review by Bank Loan Working Group (BLWG). Work continues, but the deadline of October 2019 to have a full picture has come and gone.

Defining SOFR

Despite the recent market activity and missed deadlines, the overall industry outlook is that this is merely growing pains, and as companies and financial institutions see how SOFR performs overtime this volatility will dissipate. The importance of truly understanding and adopting SOFR cannot be underestimated. Below is an overview of the four rate methods, and issues still under scrutiny.

Forward-Looking Term SOFR
A forward-looking term SOFR would have a term curve like LIBOR. This would allow market participants to know their interest rates in advance and, because it is so similar to LIBOR, would be easy to build into systems quickly. However, the development of this rate cannot be guaranteed, so we need one (or more) of the following rates as fallbacks. 

SOFR Rate Compounded in Advance
This rate would be determined by compounding the equivalent number of days for the previous time period. For instance, if a borrower wanted a 30-day SOFR contract, it would use the rate calculated by compounding overnight SOFR for the previous 30 days. The positive is that this rate is known in advance and would be operationalized very quickly, as with term SOFR. The negative is that, for longer contract periods, it could be stale.

SOFR Compounded in Arrears
This rate is determined by compounding SOFR during the interest period. If a borrower wanted a 30-day SOFR loan, the system would compound every day for those 30 days to determine the rate at the end. The positives are that this is the true, exact interest rate on the loan, it is what most other asset classes are using and it is perfectly hedgeable with swaps. The main negatives are that the final compounded rate is not precisely known at the beginning of the interest period, and, moreover, implementing the systems may not be feasible by 2021, thus putting transition at risk.* 

Simple Daily SOFR in Arrears
This rate is pulled daily, but it is not compounded. The positives are that this rate is basically the exact rate of interest, it is close to being perfectly hedgeable, and loan systems already can do this with daily LIBOR and Prime, so the operational build is modest. The negative is that the exact rate will not be known until the end of the interest period.*

*These methods will require some look-back adjustments.

Looking Forward to Transition
The AARC has published its consultation on the spread adjustment methodologies in SOFR and is seeking comments from banks by March 6 to the ARRC Secretariat (arrc@ny.frb.org).

Banks should be far into the ARRC’s Paced Transition Plan, and financial industry tech providers should be ready to provide support for the transition. Currently, AFS systems are ready to support all finalized SOFR rate calculations, and is working closely with the ARRC to help finalize definition of SOFR Compounding in Arrears. Code delivery for Compounding in Arrears is currently scheduled for 2Q2020 and 3Q2020. 

Even though there is still time before the 2021 deadline, regulators have begun thinking of adopting a more direct, supervisory approach as encouragement for banks to solidify and implement their plans for transition. Regulators will be getting more insistent because the switch will affect a massive amount of financial contracts, involving counterparties and affiliate offices all over the world. Simply put, the date when the existence of LIBOR can no longer be guaranteed is fast approaching. 

For more information on how to Stay on Track for LIBOR Transition, information on how AFS is working with the ARRC BLWG, when code will be available for AFS systems, or how we can help your institution, please contact Dean Snyder (dsnyder@afsvision.com).