SOFR too volatile?

SOFR too volatile?

August 19, 2020 | By Keith Martin in Washington, DC

Some analysts are questioning whether SOFR — the new base interest rate that will replace LIBOR in US contracts — is too volatile to serve as a good replacement.

Most debt in project finance transactions and many swaps, hedges and other contracts are tied to LIBOR. For example, a loan might require payment of floating interest at a spread of 137.5 basis points above LIBOR.

The UK Financial Conduct Authority has not committed to publishing LIBOR past 2021.

The Federal Reserve Bank of New York began publishing a secured overnight financing rate, or “SOFR,” in April 2018 as a replacement for LIBOR for US-dollar denominated instruments. Other countries have chosen other reference rates for their currencies. For example, the UK will use a sterling overnight index average called SONIA, and Japan will use a Tokyo overnight average rate called TONAR. Separate reference rates have been selected for the Eurozone, Canada, Switzerland, Australia and Hong Kong.

Debt instruments and non-debt contracts that refer to LIBOR will have to be amended or replaced.

According to some reports, only a quarter of companies may be prepared for the transition.

Many banks are choosing an approach where the parties decide later what to do rather than hard wiring a change today.

LIBOR reflects interest rates that banks charge each other in interbank lending in the London market.

SOFR is tied to rates in the US repo market.

SOFR dropped to 0.26% on March 16, doubled the next day to 0.54%, and then fell to 0.10% the day after. Strains in the repo market pushed it above 5% last September.

The Alternative References Rates Committee that has been helping to manage the transition in the United States said the following in a list of frequently asked questions in early 2019: “Overnight rates in the repo market are inherently somewhat volatile, and the dynamics that generate much of the volatility are well-known and somewhat predictable. For example, settlements of Treasury securities typically cause fluctuations in rates throughout the month, and in particular on coupon settlement dates at the middle and end of months, while balance-sheet management by some repo market participants contributes to temporary volatility around quarter-end dates.”

SOFR appears to be more sensitive to real-time market dynamics, while the three-month average of SOFR is less volatile than three-month LIBOR.

Some smaller and mid-size banks are using Ameribor, which is tied to rates set by the American Financial Exchange, an electronic exchange where banks borrow and lend short-term funds.