Libor Transition Goes on Even With SOFR Term Rate Uncertain

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The group steering a U.S. replacement for the beleaguered London interbank offered rate has said it can’t guarantee a vital last step in the process will happen this year as planned, spurring uncertainty about plans to wean the financial system off the world’s benchmark.

The Alternative Reference Rates Committee, a collection of public- and private-sector participants tasked with overseeing the Libor transition in the U.S., said this week that it can’t recommend a forward-looking term rate for the Secured Overnight Financing Rate by mid-2021, and it can’t guarantee one even by year-end because of insufficient liquidity in derivatives tied to SOFR.

The creation of a SOFR rate that extends beyond overnight has long been considered by market participants as a chicken-and-egg problem. End users don’t want to trade products tied to SOFR because of the low volume, yet liquidity is needed to create the term rates people have been craving.

The ARRC estimates that open interest in short-dated SOFR swaps total just 5.8% of Libor and 7% of fed fund swaps in the 0 to three-month maturity bucket. SOFR futures contracts have 67% of the open interest of Libor-based futures and 45.5% of fed funds.

More Liquidity

Priya Misra, the head of U.S. rates strategy at TD Securities, sees the ARRC’s lack of term SOFR as a “virtuous cycle.” Because the regulators have instructed institutions to stop issuing new Libor contracts after 2021, she said banks will use SOFR, which should create a need to hedge, spurring derivatives trading. That should in turn help build liquidity and bring more “non-SOFR players” into the market just to hedge interest rates.

“They sort of feed off each other,” Misra said. “Maybe it’s an optimistic view but in my mind term SOFR creates the chicken and the egg.”

The committee and regulators have reiterated time and again about not waiting for a term rate and utilizing the existing tools available, such as SOFR averages and index data.

Tom Wipf, chair of the ARRC and vice chairman of institutional securities at Morgan Stanley, said at the group’s symposium Monday they’ve been “very clear not to wait for a term rate” and “very clear about limited scope of use.” He also expressed concern for market participants that are waiting for a term rate for scenarios that were never discussed.

Trade Finance

In this case, the ARRC’s acknowledgment that a term rate may not be possible this year is frustrating for a small, but significant, group of players that had been expecting such a development, according to ING strategist Padhraic Garvey. These tend to be borrowers in the trade finance and working capital space, who use term rates to manage their liquidity, he wrote in a note to clients.

“There is merit in such frustration,” Garvey said. “The fact that the ARRC had sent out requests for proposal for parties to come back with suitable term SOFR compilations had led most to believe that a term rate would be available.”

Strategists at JPMorgan Chase & Co. agree.

ARRC’s unwillingness to move forward will be disappointing to those who prefer an outright term rate or that “went along with the transition, believing that there would ultimately be a near-risk-free analog to one- or three-month Libor,” according to a note by strategists led by Teresa Ho and Alex Roever.

Still, the priority has been to ensure the successful launch of the original SOFR, and to date, “it’s been largely successful,” they added.

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