SOFR and alternative RFRs - Market update
SOFR, what happened this summer?
Issuance of the first-ever SOFR notes
On 26th July, Fannie Mae issued a $6 billion floating-rate senior unsecured note based on SOFR. This was the first-ever issuance of a SOFR security. It featured 3 tranches:
- 6-month $2.5 billion at SOFR + 8 bps
- 12-month $2.0 billion at SOFR + 12 bps
- 18-month $1.5 billion at SOFR + 16 bps
The bonds received broad interest from a large variety of investors and are expected to give the secondary market more focus on SOFR-based products as well as helping the new benchmark to get broader acceptance.
On 30th July, S&P officially approved SOFR as a financial benchmark for floating rate securities which means Money Market Funds can now invest in those products. This should also bolster further issuances based on SOFR.
On 14th August, the World Bank followed Fannie Mae in arranging a floating rate debt priced against SOFR rather than dollar LIBOR. It became the second borrower to use the new reference rate within the dollar sector.
It placed a $1.0 billion 2-year FRN at 22 basis points over SOFR, the tight end of guidance with a total demand of $1.35 billion. Central banks and official institutions made up more than half the buyers; pensions, insurers and asset managers took 23 percent; and bank treasuries and corporations took about 22 percent. In addition to issuing this note, the World Bank hedged it with an interest rate swap linked to SOFR (float-float to LIBOR 3m).
On 20th August, Credit Suisse issued a $100 million 6-month debt at SOFR + 35bps, in line with their estimated funding cost using LIBOR. This is the first SOFR-linked certificate of deposit issued by a bank.
SOFR futures: volumes ticking up
On 19th July, the volume of SOFR futures exchanged reached more than 100,000 contracts with open interest surpassing 20,000 contracts.
On 8th August, CME announced that SOFR volumes increased 121% in July. Although volumes are still relatively low, there seems to be a healthy uptick in futures transactions based on SOFR. This trend is continuing through August.
SOFR swaps: early start but liquidity is thin
The first SOFR swaps traded during the month of July. We have seen swaps cleared through LCH in the $50 to $250 million notional range and up to 2y maturity. The payoffs below were reported.
- SOFR compounded v fix zero-coupon
- SOFR compounded v FedFunds compounded basis zero-coupon
- SOFR compounded v Libor quarterly basis (very limited trading)
LCH started clearing SOFR-based interest rate swaps and basis swaps in July. LCH requires margining based on FedFunds rather than SOFR which has been questioned by some institutions as this inherently creates a basis risk.
CME and ICE announced, subject to regulatory approvals, they would clear SOFR swaps early Q4 2018.
From overnight SOFR to compounded SAFR?
On July 19th, the US Federal Reserve Governor Randal Quarles mentioned that he would encourage the Fed to publish a benchmark based on SOFR to address the issue that the new benchmark is not comparable to LIBOR as a term rate.
He suggested this index could be called SAFR (Secured Average Financing Rate) and would effectively be calculated as a compounded average of daily SOFR fixings.
Such an index would alleviate some of the concerns raised by market participants around daily compounding methodologies, cashflow management and not being able to compare SOFR to LIBOR. This is however very early stage and the Fed has not communicated further on this topic.
What is happening in other jurisdictions?
European Union - ESTER, GC Pooling Deferred or RepoFunds Rate?
In the EU, the European Commission required the industry to move away from EONIA and EURIBOR and either replace them with new benchmarks or revamp the existing benchmarks with a firm deadline set for Q1 2020. Any existing or new benchmark will have to comply with the European Benchmark Regulation (BMR) that came into force, including provisions, on 1st January 2018.
The ECB's Governing Council announced in September 2017 its intent to publish a new rate called ESTER (Euro Short-Term Rate). It will be officially published by October 2019 and based on data already available to the Eurosystem. The methodology for calculating this rate will be in line with the international standards set by IOSCO (International Organization of Securities Commissions).
ESTER is based entirely on unsecured borrowing deposit transactions in euro that are reported by the 52 largest euro area banks in the ECB's money market statistical reporting (MMSR).
From the ECB: "ESTER will reflect the wholesale euro unsecured overnight borrowing costs of euro area banks and will complement existing benchmark rates produced by the private sector, serving as a backstop reference rate."
To help market participants assess the impact of the new benchmark and transition their portfolios, the ECB published pre-ESTER figures covering historical data starting 15 March 2017.
In addition to ESTER, 2 other benchmarks have been put forward as viable alternatives. Unlike ESTER, both are based on secured transactions and published by independent entities.
- "GC Pooling Deferred Index" published by STOXX
- "RepoFunds Rate" produced by NEX and BrokerTec
The European Central Bank (ECB) has recently conducted a consultation to assess which of these 3 candidates should replace the existing euro benchmarks. It looks like ESTER is the preferred option for most market participants, but the rate will be officially published just a few months before Q1 2020 which is a concern.
United Kingdom - Reformed SONIA
The Working Group on Sterling Risk-Free Reference Rates was established in 2015 with the goal to implement the Financial Stability Board's recommendation to develop alternative RFRs to replace existing LIBOR-related benchmarks.
In April 2017, SONIA, the rate published by the Bank of England, was recommended as the preferred choice as it was undergoing a process of reform to ensure its compliance to IOSCO and FSB regulations.
On 23rd April 2018, the Bank of England announced that the reform of SONIA was implemented with a new methodology to ensure its robustness and a publication time of 9am on the following London business day.
Japan, Switzerland, Canada - TONA, SARON and CORRA
Other jurisdictions such as Japan and Switzerland have already chosen their new RFRs.
In Switzerland, the previous benchmark TOIS was discontinued in December 2017 and replaced by the Swiss Average Rate Overnight (SARON).
In Japan, the Tokyo Overnight Average Rate (TONA) was chosen by the Bank of Japan as the new RFR for all Yen denominated transactions.
In Canada, the Canadian Alternative Reference Rate Working Group (CARR) was established by the Bank of Canada in March 2018. It is tasked to review and enhance the existing Canadian overnight risk-free rate, the Canadian Overnight Repo Rate Average (CORRA) as well as identifying and developing a Canadian term risk-free rate benchmark which would act as a complementary reference rate and operate alongside the Canadian Dollar Offered Rate (CDOR).
Is it time to look at LIBOR fall-back options?
With some of the new RFRs not published yet and market liquidity still very thin with the RFRs already made available, many market participants believe that a version of LIBOR should be made available after 2021 to cope with the transition.
The International Swaps and Derivatives Association (ISDA) recently launched a consultation for a fall-back mechanism should LIBOR cease to be published after 2021.
The consultation covers multiple scenarios assuming IBORs are permanently discontinued. It applies to AUD, CHF, GBP and JPY. Responses to this consultation are due by 12th October.
Should a fall-back LIBOR rate exist, it is expected to be based on IOSCO compliant benchmarks. In most jurisdiction, this means looking at how to relate overnight RFRs to a term rate such as LIBOR with two very important aspects: how to compound an overnight rate into a term rate and what credit spread should be applied to that rate?
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