The secured overnight financing rate will become the main replacement for Libor in US financial markets, according to a number of experts speaking at the International Swaps and Derivatives Association’s annual general meeting, despite the emergence of some alternative lending rates.
The development of the SOFR market in the US has been slow, with interest-rate swaps tied to the new reference rate making up less than 2% of US trading volumes, according to data from IHS Markit, compared to over half of sterling swap trading volumes being linked to the UK's sterling overnight index average, or Sonia.
US loan markets, in particular, have been reluctant to move away from Libor and some borrowers are exploring the use of credit-sensitive reference rates instead of SOFR, which is virtually risk-free.
Despite the emergence of these alternatives and SOFR’s sluggish start, speakers at ISDA’s virtual AGM were confident SOFR would ultimately replace US dollar Libor as the market standard and that that transition would accelerate in the coming months.
Tom Wipf, vice-chairman of institutional securities at Morgan Stanley, said that regulators’ expectation that no new financial contracts should reference Libor after the end of this year – combined with industry guidelines to discard Libor after June – should cause liquidity in Libor to drop “dramatically”, and to increase in alternative reference rates like SOFR.
“Between June and December, whether it’s the best practice recommendations or the supervisory hard stop, we should see a pretty meaningful transition,” said Wipf, who also chairs the Federal Reserve’s Alternative Reference Rates Committee.
“At that point, I believe that the driver will be liquidity and the markets will go where the liquidity is, which in US dollars we believe will be SOFR,” he said.
Even though various US dollar Libors will continue to be published until mid-2023, regulators have said no new contracts referencing Libor should be struck after 2021. With that deadline fast approaching, focus has intensified recently on the US loan market, which has been particularly slow to drop Libor.
Paradigm shift
Sonali Theisen, head of fixed-income electronic-trading and market structure at Bank of America, told the ISDA conference that the US loan market is larger and more complex than in other regions.
“The market has struggled with how to price loans over a risk-free, backwards-looking rate in a way that balances for both normal market conditions and times of stress,” she said.
The industry has responded by developing other rates that incorporate a measure of credit sensitivity. Bank of America sold a US$1bn floating-rate note linked to Bloomberg’s “BSBY” index in April, and has also done a BSBY-linked loan and traded a BSBY-SOFR basis swap, Theisen said, adding that it is prudent to give the market choice at it undertakes this “massive paradigm shift”.
“BofA anticipates that there will be more than one rate in a post-Libor world and we’re actively supporting the development of [credit-sensitive] products alongside SOFR for cash markets. And we also think consequently then there will be a need for derivatives to support those … markets,” she said.
Even so, many speakers at the ISDA AGM indicated SOFR would become the predominant rate in the US.
Jack Hattem, a managing director at BlackRock and ISDA board member, acknowledged that some swaps users have a need for credit-sensitive rates and that other products will coexist alongside SOFR. But he added: “Our view is still that the majority of the liquidity is going to be in the SOFR curve itself.”
Growing volumes
Despite the low volumes in SOFR-linked swaps so far, experts say the market is growing. If it was a currency in its own right, SOFR would be LCH’s sixth largest, said Philip Whitehurst, head of service development for rates at the UK-based clearinghouse.
“SOFR volumes are growing nicely,” said Whitehurst. “This is really going to be a dollar swap market that is very much SOFR-based in the future.”
Edwin Schooling Latter, director of markets and wholesale policy at the UK’s Financial Conduct Authority, noted that over 97.5% of outstanding sterling derivatives will switch to Sonia, thanks in part to ISDA’s Fallbacks Protocol, a safety net that automatically converts old contracts to alternative reference rates if Libor ceases to exist.
He predicted “close to 100% of [the US swaps] market is going to be based off SOFR” with anything else looking like “a pretty small niche”.
“The experience that we’ve had in the UK in sterling can give very substantial confidence [in the risk-free rate] model, whether it’s Sonia or SOFR: it works, across economic use cases,” said Schooling Latter. “Sonia has emerged extremely strongly as the centre of gravity of sterling interest rate markets.”
Certainly, some derivatives users have concerns over credit-sensitive rates. “Ultimately I think it gets back to liquidity – how are the banks going to be able to hedge the derivatives that they offer naturally?" said Chris McAlister, global head of derivatives trading at Prudential Financial. "With that, I would expect that liquidity is going to come with additional cost to hedge that."