Keeping SOFR pure and simple

The Alternative Reference Rates Committee (ARRC) in the US has significantly softened its target to make term Secured Overnight Financing Rates (SOFR) available.

There had been an implicit expectation for the term rate to become available at some point in 3Q21. Now, the ARRC is suggesting that it might not come in 2021 at all.

This is a massive setback for a small but a not insignificant rump of players that have been expecting SOFR term rates; typically borrowers in the trade finance and working capital space, to manage their liquidity well.

In the UK, where Sonia terms rates are available, the take-up is running in the area of just under 10% of volumes. While that implies over 90% of new volumes will be in Sonia in arrears, that still leaves a sizeable sub-section that would be un-catered for if we extend these proportions to the US.

The logic for the ARRC’s reluctance to accelerate efforts to get a SOFR term rate is centered on two points. First, development of a term rate was always contingent on having suitable volumes built in SOFR futures and derivatives, and the ARRC has concluded that such volumes are not in evidence as of yet. And there is an implied presumption that such volumes may not build adequately and in a timely manner in the coming months. Second, and related to this, the ARRC is keen not to fall short of suitable volumes, to avoid legitimacy pitfalls that Libor fell into.

To this end, the ARRC is urging participants to push ahead without a term rate. There is an underlying pressure for market participants to look for alternatives to SOFR term rates, and for any future term rates that might eventually come to be used in limited cases. This stance has been supported by various Fed studies that show a minimal basis between SOFR in arrears versus SOFR in advance for shorter tenors (e.g. 1mth). However, SOFR in advance is not the best predictor of SOFR in arrears for longer tenors (e.g. 6mths).

For most players in both loans and derivatives markets, the lack of a term rate is not debilitating. The swap derivatives market was always and will continue to be based off a SOFR in arrears structure.

Partly in consequence, the loans market will have a very similar structure, where the preference is to have so-called “Daily simple” as a reference, where the SOFR rate is applied on a daily basis. In arrears and daily simple are similar. Both are in arrears rates, the only material difference being an implied averaging rather than a compounding computation in the classic in arrears computation.

But what about players that had been holding out for SOFR term rates?

The implied suggestion from the ARRC is to use something else. There are Federal Reserve published SOFR indices that could be employed. Not ideal for longer tenors in trade finance (say out to 12 months), but at least a usable reference. As an aside, a similar implied solution is suggested by the Swiss authorities, which have stated for some time that they will not have a term rate available, ever.

While this is not a debilitating development per se, it is quite unwelcome in the arena of supply chain financing. Either these players will need to significantly change the way they operate, or to use what they would describe as a sub-optimal solution rate (even “in advance” rates are technically calculated from historical rates). While this is a minor aspect of the market, unease here does not help against a backdrop where there is an ongoing push from the official sector to switch to SOFR-linked business this year.

The counter argument is this news removes a waiting game that had been ongoing.

The ARRC has now clearly advised those waiting for term SOFR to proceed without it, for 2021 at the very least. While disappointing for players that were waiting for SOFR term rates, the urgency now is transformed to moving on, and employing whatever alternatives are available.