Deep Liquidity: Officials Backing SOFR Point to the Repo Market

# Banking

# Risk Management

ARRC Chair Tom Wipf and Nate Wuerffel of the New York Fed on the benefits of SOFR vs. other rates.

Know your Libor replacement term rate inside and out. That was the message delivered to regional bank treasurers by top officials leading the effort to replace USD Libor that has led to the development of the secured overnight financing rate (SOFR).

More than $200 trillion in transactions are priced over Libor, but the interbank lending market on which the floating-rate benchmark is based has shrunk to few if any transactions daily, a fate regulators do not want to see repeated.

A choice of floating-rate benchmarks may emerge, but bankers must scrutinize them. “It begins with thinking about your own organization and what these different rates do, their construction and the data behind them, and how they perform over time,” Tom Wipf, chairman of the Alternative Reference Rates Committee (ARRC) and vice chairman of Morgan Stanley, told members of NeuGroup for Regional Bank Treasurers.

Arriving at SOFR. The ARRC, comprising public-market representatives and sponsored by the Federal Reserve and the Federal Reserve Bank of New York, reviewed a wide range of potential Libor replacement reference rates, including unsecured credit-based rates and other secured rates, according to Nate Wuerffel, deputy head of the New York Fed’s open market trading desk for domestic markets.

It chose SOFR because it is generated from the highly liquid, overnight treasury repurchase agreement market, with upwards of $1 trillion transactions daily.

“That’s a market that’s not going anywhere,” Mr. Wuerffel said. “It’s super durable and deep, and a reference rate you can rely on.”

Drawback. SOFR is a secured rate that can tighten dramatically during periods of market stress. Regional and community banks worry that their returns from SOFR-priced assets could plummet while their cost of funds increases.

In response, several reference rates incorporating credit risk have emerged, including the American Financial Exchange’s (AFX) Ameribor and the Bloomberg Short-Term Bank Yield Index ( BSBY ).

Due diligence required. The credit-risk alternatives aggregate rates from several sources of bank funding, but their daily transaction volumes are significantly lower than SOFR’s—typically less than $10 billion daily.

Mr. Wipf noted that some are heavily weighted in commercial paper (CP), “markets that are small and some might argue getting smaller.”

Their liquidity becomes ever sparser as their term structure tenors lengthen.

Mr. Wipf acknowledged that alternatives such as Ameribor may reflect banks’ marginal cost of funds more closely. However, so far few transactions have been priced over them, and ‘as we move out to more industrial-size transaction volumes, we don’t want to end up right back where we started.”

SOFR’s biggest hurdle. Peer group participants pointed out that indeed all the Libor replacement rates now in the works have some issues. The very biggest concern about SOFR was its lack of a forward-looking term rate, which at the start of the billing cycle provides borrowers with their interest payment due at the end; overnight rates, instead, must be averaged daily, and borrowers learn their final rate only a few days before the payment is due. In April, CME Group announced the availability of a term SOFR in several popular tenors.

“I want a credit sensitive and forward-looking rate—that’s my perfect world,” said one bank treasurer. “But if I have to choose one, I’ll pick the term rate.”