Geeking out, I just finished reading the second report from the Alternate Reference Rates Committee that was just published jointly by the Financial Stability Board (FSB) and the Financial Stability Oversight Council (FSOC) in cooperation with the Alternate Reference Rates Committee (ARRC). Does that scream bureaucracy in full, or what? The report runs 40 pages, awkwardly pats itself on the back (with a net back-patting surplus allocated amongst the Federal Reserve, the U.S. Department of the Treasury, the U.S. Commodities Future Trading Commission and the Office of Financial Research) for confirming that we need a LIBOR replacement and the Secured Overnight Funding Rate (SOFR) is way better than the Effective Federal Funds Rate (EFFR) or the Overnight Bank Funding Rate (OBFR). Ergo SOFR is the ARRC’s preferred alternate rate upon the expiry of the spavined LIBOR.
The data gnomes at the Federal Reserve Bank of New York (FRBNY) started publishing SOFR on April 2 and, as a bonus, aver that they will be publishing last year’s data (in addition to the three years of data we already have) to help the market understand SOFR. Moreover, the regulatory community is floating a trial balloon on some fancy averages to smooth out SOFR’s fractal character into something more usable. Assuming all that really happens, that’s a good start. Keep in mind that SOFR is probably not going to be the alternative rate you’ll be using in your deals; the ultimate replacement to LIBOR will be a derived term rate from a curve constructed from SOFR by…someone.
Unhelpfully, the ARRC’s largely self-congratulatory missive reports that the ball has not moved much on getting to a term product, albeit it is defined as a “goal.” According to something called the Paced Transition Plan, or PTP (the alphabet soup is just killing me here), a term reference rate based on SOFR is supposed to be available by the end of 2021. Hello! Paced!? Like a sloth in hot pursuit of some juicy shoots? December 2021 is when LIBOR may well disappear. Couldn’t we get a little runway baked into the schedule? Don’t we need at least a year of term-based SOFR to really understand how it will perform in comparison to trusty old LIBOR?
Moreover, the report admits that SOFR does not contain “a meaningful credit component.” I understand that to mean that as LIBOR moved with reasonable rapidity, in response to changing credit conditions in the broader economy, SOFR might not. Response to credit conditions might be significantly suppressed when we’re talking about what amounts to daylight loans on treasuries. That means that even when term rates are developed off SOFR, they are going to be very different from LIBOR. Maybe that’s good for borrowers in a rising rate environment where there’s more volatility and more risk, but not lenders; and by the way, vice-versa when rates are going down.
Lots of fancy talk here about all the hard work that’s gone on into getting to SOFR, and I’m sure they are all exhausted by all this thinking, but we actually need some doing.
So, to recap. We have a spot rate, we have some math that at least someone thinks will smooth out the noise around daily pricing of the SOFR which will make it possible to produce a useful forward curve. We have some regulatory assurance that “someone” will create a futures market off the rate and construct a forward curve which can be used to price term product. But for all that, we don’t have an effective LIBOR alternative yet.
The tone of this report is “don’t worry, we’ll get to that” all while reiterating the trope that I’ve heard too often recently: legacy deals will all have burnt off by the time the alternate rate is available and we’ll all move in lock step into the broad, sunlit uplands of a better world of post-LIBOR SOFR. That’s silly. While the 2018 cohort of financial assets may have indeed burnt off by 2021, we will still be creating “legacy” documents right up until the moment the alternate rate is uniformly embraced. The legacy problem is not going away.
The other issue that is getting zero attention from the regulators so far is how this conversion will actually happen. Is it like a Le Mans start where the government throws down the alternate rate on some Friday morning at 10:00 a.m. and by Monday, we are all supposed to have a new rate embedded in all financial assets? That seems a much larger headache than our government seems to want to admit.
For those of us who are in the trenches and have to include alternate rate language in documents right now, a little bit of guidance would have been very much appreciated. But, never fear, the ARRC has formed four new working groups on business loans, mortgages, floating rate notes and securitizations. I shudder gently with the frisson of excitement that the Fed is on the case and has already conducted “initial research into exposures to USD LIBOR and the common forms of contract language.”
Doesn’t it seem that, even grading on the curve, we’re getting an “A” on process but that we’re seeing a “D” on actually getting something done here? People, we really need some help here, and soon. We cannot wait too much longer.
When I ask about how we get to a term rate, officials at the Fed blithely respond that the market will, of course, provide (a touching expression of fealty to the invisible hand of capitalism from organizations dedicated to the proposition that unfettered capitalism is broadly bad and needs a keeper). But how is that really going to work and which term product is going to be sufficiently “IOSCO compliant” to become the standard? The ARRC is floating at least four different ways to construct term-based SOFR. The CME Group announced that it’ll start producing monthly and quarterly SOFR futures quotes for one month, three month and six month terms starting on May 7, 2018, so maybe they’ll do our work for us, but this could become the Wild West where there’s multiple alternatives and individual counterparties may have to pick amongst them? And what about the hanging chad of some rump LIBOR remaining around when SOFR pricing is available? ICE has repeatedly and proudly declared it will continue. Think of the turmoil if some zombie ruin of LIBOR is out there still baying at the moon. Without guidance, chaos may ensue. The uncertainty and potential variability all seem completely intolerable.
And don’t forget we still have not begun to deal with the absence of a credit component in the index. All the legacy alternate rate language in circulation that I’ve seen essentially compares the new alternate rate to LIBOR on some specific date and adds that to the spread on the alternate rate. That takes care of Wednesday. But if the alternate rate doesn’t really capture credit risk, the adjusted rate is simply not going to perform over time. It won’t work on Thursday. Who bears the risk of that?
What our market needs right now is a focused effort around transition language for floating rate product. It would be useful if the Fed or other denizen of the Olympian heights of government would give us its view of alternate rate language and would facilitate development of a certain amount of homogeneity in legacy product over the next four years.
So enough already on the studying. Could we get some help down here in the trenches?