A View from the Alternative Reference Rates Committee (ARRC) on the Progress Towards SOFR
The end of USD LIBOR is in sight. The seven-year process represents an incredible amount of work from the Alternative Reference Rate Committee (ARRC) and other working groups to replace previous LIBOR reference rates embedded in more than $200 trillion worth of financial contracts.
At the recent Tradeweb virtual event, “The Year Ahead in Derivatives Trading”, our Head of Senior Relationship Management Keith Fell, spoke to Tom Wipf, Vice Chairman at Morgan Stanley for Institutional Securities and Chairman of the Alternative Reference Rate Committee (ARRC), on why the process has evolved the way it has and to get a sense of the next stages of this seismic market transition. Below is a summary of their discussion.
Latest on LIBOR
At the end of 2020, two main announcements around LIBOR (London Inter-bank Offered Rate) were issued. The first announced was the final cessation of U.S. dollar LIBOR in June 2023, whereas the second was supervisory guidance by regulators prohibiting the use of new LIBOR after the end of 2021. The clarification of these two deadlines means we are now able to carve a clear path forward for the transition from LIBOR in the form of timing for a “roll down corridor” (lasting from the end 2021 to June 2023). Recent use of the fallbacks protocol from International Swaps and Derivatives Association (ISDA), as well as fallback language recently published by the ARRC, have helped to de-risk the work involved within this roll down period. This fallback language (covering perpetuals, trust prefers, floating rate notes and securitizations) has now been legislated by the Federal Reserve Bank of New York and is currently being worked on at a federal level. Indeed, a recent ARRC Progress Report identified approximately $223 trillion in outstanding USD LIBOR contracts are in a much safer place than they would have been seven years ago, now that the status of those fallbacks is known.
The creation of “Term SOFR” (Secured Overnight Financing Rate (SOFR) term rates) is the final step in ARRC’s transition plan, and refers to a forward-looking SOFR rate that covers a period longer than a business day, for example one-, three-, six-, and twelve-month periods. The backward-looking calculations that are used to calculate these rates present their own challenges regarding the certainty of payments for borrowers, in that until the derivatives market really shifts to SOFR, there will be problems in having enough underlying data to create that rate. What is essential is that we avoid the same problems that occurred under LIBOR when not enough trades were supporting too many contracts and an inverse pyramid was created.
ARRC has issued a set of key principles to be used as guidance while considering the necessary conditions for a SOFR term rate. The principles to be followed include: meeting the ARRC’s criteria for alternative reference rates; being rooted in a sustainable base of derivative transactions over time, and; having a limited scope of use in proportion to the depth and transactions in the underlying derivatives market. In short, ARRC is intent on delivering Term SOFR, but wants to ensure there is enough volume to do so. A massive pool of liquidity in SOFR is expected on the horizon, however, given that a large portion of the $223 trillion tied up in LIBOR is going to be rolled down before 2023, if 65% of those contracts mature, that would mean at least $75 trillion worth are going to flip to SOFR in June 2023.
Since the discussion aired, CME has been selected by the ARRC as the administrator for term SOFR once market indicators for the term rate are met.
In terms of moving forward and starting to use these rates sooner rather than later, the market needs to start streaming prices and quoting in SOFR rather than LIBOR. Tradeweb has begun in earnest to help get the market moving on the path forward; all of our protocols and functionality being used for LIBOR can be used for trading SOFR. We are pleased to report that we have seen a move forward in terms of an upswing in dealer streaming in SOFR which has occurred lockstep with ARRC developments.
Financial technology plays an important role in this period of transition as market participants need to mitigate their operational risk. Compression trading stands to serve the market by automating the conversion of a large book of bilateral swaps, for example. This automated process can help firms reduce the notional and choose beneficial rates that consider the timing of the market.
“No to LIBOR 2.0”
It is vital that the industry does not repeat the mistakes of the past - what we want to avoid at all costs is a ‘LIBOR 2.0’. SOFR represents a solution that is transparent, robust, durable and is based on a trillion dollars in transactions every day; and the combination of SOFR, SOFR averages, and Term SOFR should be able to cover most, if not all products. In the meantime, industry participants need to ensure that they have a proper understanding of the rates. Do they make sense for your organization? Are they durable and robust? It is in this sense that technology can allow firms to control their own destiny in relation to this work, and not sit around waiting to navigate a large number of fallbacks just before the deadline.