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IHS Markit to Publish Daily Credit Spread Adjustment for SOFR from Q2 2021
20 January 2021
With less than a year until the anticipated sunsetting of many
global interbank offered rates (IBOR), the Alternative Reference
Rates Committee (ARRC) has recommended the Secured Overnight
Financing Rate (SOFR) to replace USD LIBOR. Since its emergence in
2018, some liquidity in SOFR-linked financial instruments has
developed, but many legacy products and industry segments are
struggling to adapt to the new rate.
As a leading index
provider with a strong credit franchise, IHS Markit is
well-positioned to help the industry overcome the challenges
presented by SOFR - specifically by addressing the differences in a
secured versus unsecured rate.
With this in mind, IHS Markit is developing a USD credit spread
adjustment which utilizes transaction data on commercial paper,
certificates of deposit and corporate bonds issued by banking
institutions. IHS Markit expects to deliver and publish the daily
USD credit spread adjustment to the market beginning in the second
quarter of 2021.
Addressing Industry Concerns
There are two main concerns raised by financial institutions on
the transition towards SOFR:
1. The first concern is that SOFR is an overnight rate, whereas
USD LIBOR is a term rate. To use SOFR in financial contracts, the
overnight rate must be compounded to a term, typically in arrears,
which is a major change to the way financial instruments are booked
and priced today with USD LIBOR.
2. The second concern is that USD LIBOR embeds a bank credit
component. SOFR does not have this credit component as it is based
on secured repo transactions. This concern gained additional focus
in spring 2020 due to the market volatility experienced during the
COVID-19 pandemic. In times of market distress, USD LIBOR will tend
to widen whereas SOFR will tighten. To be compensated, lenders need
to adjust secured reference rates so that they include a credit
risk component of borrowers or issuers. This credit risk component
must also move in line with market dynamics so that credit
exposures are properly captured in financial instruments over
time.
"In order to achieve a timely, smooth and successful transition
to SOFR, some market participants will need an alternative
mechanism to capture the dynamic credit component that is embedded
within USD LIBOR," said Julien Rey, executive director and global
IBOR transition lead at IHS Markit. "Credit markets move
independently of interest rates, at times in opposite directions,
and in the post-LIBOR era, it will behoove banks and borrowers
engaged in lending activity to include a credit spread adjustment
that reacts in a timely manner to credit markets. The credit spread
will help ensure lending activity does not veer too far
off-market."
IHS Markit will use an advanced adjustment methodology paired
with robust and timely market data to deliver a successful credit
spread. This approach complements the imperative to draw upon a
deeper, more diverse data set; including additional institutions
results in a more holistic view of the market and directly
addresses concerns that looking only at the LIBOR Panel Banks will
not be inclusive enough.
Additionally, dynamic thresholds ensure our methodology reacts
to changes in funding behavior programmatically and does not rely
on arbitrarily selected rigid thresholds. Our fallback methodology
is designed in a manner so that a credit spread will be published
daily. The result: a robust and reliable credit spread adjustment
that brings market participants the flexibility to apply a spread
to the rate component of their choosing, such as compounded SOFR or
a term rate.
IHS Markit provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.