SOFR, so good
With a market footprint of more than $200 trillion, the London interbank offered rate (Libor) has been referred to by some as “the world’s largest number.” It is a benchmark rate—technically a series of rates across five currencies and seven maturities—used for many financial instruments, including derivatives, securitizations, floating-rate notes and bank loans. But caught up in scandal and weakened by reforms on financial institutions and money markets that led to a drop in assets referencing it, Libor’s days are, well, numbered. U.K regulators have announced their intention to phase it out by the end of 2021.
The magnitude of the obstacles to do away with Libor is enormous. It is estimated that in 2016 there was $200 trillion in exposure to financial instruments tied to some measure of Libor, with the majority of that in derivative contracts. While 82% of this exposure, including most money market funds at present, is estimated to mature by the end of 2021, roughly $35 trillion, such as loans and floating-rate notes, have maturities beyond that date. This staggering amount of legacy contracts presents significant legal, operational, accounting and investment challenges.
Efforts have been under way to wean issuers and investors off Libor for some time. In 2014, the Federal Reserve formed a committee to find a replacement. It recommended the Secured Overnight Financing Rate (SOFR), an index based on transactions in the market for overnight repurchase agreements collateralized by Treasury securities. Its transaction-based nature and broad-based volume make SOFR an attractive choice for a benchmark rate—its average daily volume recently eclipsed $1 trillion.
It isn’t as simple as switching one rate for another, unfortunately. Daunting questions must be addressed, including when and how the switch takes place and how to account for the difference in economic value at the time of transition. While the risk-free nature of the rate makes it desirable for hedging, SOFR lacks a credit component and term structure, which is an issue for products such as floating-rate securities. Because most money funds do not currently have Libor exposure beyond 2021, the money market industry has the luxury of time to create strategies to address issues.
To date, issuance of SOFR-based floating-rate securities has exceeded $200 billion and the volume of trading and open interest in SOFR futures continues to grow. But far before SOFR is ready to take over for Libor, cash managers and investors need a game plan for current and new exposure. 2021 may seem a long way away, but it’s never too soon to start.