BankingTerm Sofr may bypass much of the market’s need for CSRs

Term Sofr may bypass much of the market’s need for CSRs

The formal recommendation of term Sofr by the ARRC takes away much of the use case for CSRs

The term Sofr rate recently endorsed by the the Alternate Reference Rate Committee (ARRC) may pre-empt most of the market’s need for credit-sensitive rates (CSRs), striking just the right balance between policymakers’ zeal for risk-free rates and the industry’s appetite for a forward looking term structure.

Courtesy of the formal stamp of approval by the ARRC, a forward looking term rate tied to Secured Overnight Financing Rate (Sofr) and administered by the CME looks set to bypass most of the use cases for CSRs, rates that global regulators had recently ramped up their warnings against.

Peter Phelan, former deputy assistant secretary at the US Treasury’s capital markets office and currently advising Deloitte’s centre for regulatory strategy, says there are now only a few niche use cases left for CSRs.

“Credit-sensitive rates were attractive because of the term structure that they had. The ARRC’s recommendation to move forward with term Sofr really takes away a lot of the utility of CSRs.”

“The US market wants a term rate,” added Mark Tibberts, partner at Baker and McKenzie.

“They want a rate that plugs in and is forward looking. Something where they can lock in an interest rate and pretty much duplicate the way Libor works.”

The formal recommendation of a term Sofr by the ARRC had been long awaited by the lending sector in particular, as the term structure of this type of rate allows borrowers and lenders to know the benchmark interest rate on a debt contract at the beginning of each interest period – in a similar manner to Libor.

“What the market really cares about from the lender side is that without a term rate, you’re not actually capturing the forward-looking nature of lending,” said Kyle Lakin, partner at Freshfields Bruckhaus Deringer.

On the borrower side, a forward-looking rate also allows for more certainty on repayment. “Corporate treasurers really want to be able to tell their board three months from now, here’s our interest payment. Without some sort of forward-looking component, it’s very difficult,” he said.

On the broader securities markets, “using term SOFR would operationally (if not economically) feel a lot like using Libor,” PwC analysts wrote in an update on Libor transition last month.

“Some market participants have recently been looking to forward-looking, credit-sensitive alternatives to USD Libor, in part due to concerns about the complexities of using a daily in-arrears rate. With a growing chorus of regulators cautioning against the use of credit-sensitive rates (CSRs), we can expect institutions concerned about possible regulatory scrutiny to look toward term SOFR instead.”

ARRC had made its endorsement conditional on more robust trading activity in SOFR derivatives to ensure that the rate, which is based on the pricing of futures transactions, would be supported by enough underlying market liquidity – a trend that started to build up more pronouncedly as the Commodity Futures Trading Commission’s Sofr First initiative came into effect on July 26, incentivising interdealer brokers to base USD swap trading on Sofr.

On the first day of Sofr First, 18 percent of DV01 (dollar duration, or the dollar variation in a security’s value per unit change in the yield) risk was traded using Sofr, compared with only 6 percent in June. Three days later, ARRC officialised its endorsement.

“Perhaps in a nod to the slow pace of progress — or perhaps with an eye on stemming the rise of CSRs — the idea of term Sofr playing a bigger role in the transition away from Libor appears to be gathering momentum,” said PwC.

The next Sofr-first step – officially kicking off on September 21 – will concern interdealer cross-currency swaps and is poised to equally boost liquidity in related derivatives markets.

A multi-rate world

Phelan, however, argued that some lenders may continue to gravitate towards CSRs instead of term Sofr rate – a decision, he said, that will be based on market competitiveness.

“These are competitive decisions,” he said. “A bank might feel the need to add credit-sensitive spread for the risk management benefits, other bank may feel that they don’t need to.”

William Shirley, counsel at Sidley Austin, said there were regulatory concerns that overuse of term Sofr could undermine the market determining the rate.

“There are concerns about various markets’ overwhelming the underlying futures and derivatives market that sets the term rate.

“The ARRC recommended that, as a matter of best practice, the derivatives markets and a number of cash markets should not jump into term Sofr. They don’t want the tail wagging the dog,” he said.

The ARRC did indeed confirm a nuanced approach to the use of term Sofr in its latest update to best practices, reinstating some of its original assessments.

In 2019, the Committee had in fact pointed out that different financial instruments should use different reference rates – and that legacy and new contracts warranted two separate approaches.

“While […] term rates can be a useful tool for some and an integral part of the new ecosystem, hedging these rates will also tend to entail more costs than using Sofr directly,” the Committee had clarified.

“For this reason, the ARRC sees some specific productive uses for a forward-looking Sofr term rate, in particular as a fallback for legacy cash products referencing Libor and in loans where the borrowers otherwise have difficulty adapting to the new environment.”

For example, the body refrained from supporting the use of term Sofr “for the vast majority of derivatives markets,” recommending to limit it “to end-user facing derivatives intended to hedge cash products (such as loans and bonds) that reference term Sofr.”

PwC analysts overall expected some parts of the market to continue explore different reference rates, including CSRs.

“Whatever rates specific pockets of the market might eventually gravitate toward, it now appears clear that the multi-rate environment is here to stay.”

Alongside the newly-available term Sofr, the future market is likely to feature products that reference Sofr averages in advance or arrears, simple Sofr or even CSRs, the PwC report said.

“Risk managing […] different exposures, which is dependent on developing derivative markets in those different rates and conventions, might result in a diverse portfolio of loans and swaps that look and function very differently.”

“Financial institutions will need to be prepared to transact in a myriad of rates and conventions, and manage potentially complex hedging relationships associated with a diverse portfolio,” it concluded.

(Additional reporting by Anna Brunetti)


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