Hedging Video Series: “SOFR” [Chapter 2] — By Jillian Mariutti
This is the second episode — focusing on SOFR — in a series of eight videos on Hedging.
Chapter 2: SOFR
The ARRC voted SOFR, which stands for Secured Overnight Funding Rate, as the alternative rate to LIBOR. SOFR will be a secured overnight rate based on cleared and bilateral repurchase transactions on US Treasuries. So basically, looking at the extremely liquid, high volume repo market:
To refresh, the Repo market works as such: I have treasury, I’ll lend to you for pile of cash, with expectation of buying it back in a day, one week, one month, there are different intervals. You hold the treasury, I hold the pile of cash. I have to pay you interest on that cash. That interest rate is the repo rate.
SOFR will incorporate data from ~$600-$800 billion in daily repo transactions.
LIBOR is unsecured rate whereas repo transactions are secured (you have my treasury as collateral). Comparing these two rates is comparing apples to oranges (unsecured rate vs secured rate) so it begs the question is there going to be some sort of adjustment to SOFR – spread to SOFR to make it an unsecured comp? That’s TBD.
Timing: It will likely be at least 3 to 5 years until it is a viable LIBOR alternative. We expect the phase-in to be gradual and LIBOR is likely to exist for a prolonged period and in parallel with the new SOFR index.
Transition plans include the following milestones:
- The Secured Overnight Financing Rate (SOFR) is expected to begin being published by the Federal Reserve daily at 8:30 AM EST beginning Q2 2018.
- Regulators, banks, exchanges and CCPs (clearing houses) will work to create infrastructure for futures to trade on SOFR by the second half of 2018
- OTC derivatives market for SOFR is expected to develop as liquidity increases.
- ISDA is working on an amendment to the 2006 Definitions to improve the emergency fallback language to the IBOR benchmarks, and will be publishing a report Q1 2018 that will have more information on this
Implications: We all need pay closer attention to replacement language in loans: Most common is the Fed Funds fall back.
Another TBD: With one fell swoop you can change the definition of LIBOR to say hypothetically it is equal to SOFR +10. Then every contract that references LIBOR, References SOFR. But it’s still TBD on how they will handle.
There have been no deals derailed from this news. People feel confident everybody wants mutually agreeable solution-a lot of market participants are on both sides of trade.
To quote a member of the Federal Reserve Bank of New York, “SOFR so good…”