Coming to Terms With SOFR

With forward-looking SOFR term rates not expected to be available anytime soon, market participants will have to rely on a calculated term rate. In addition to the increasing operational complexity that comes with a calculated term rate, participants have to decide which version of a calculated SOFR term rate to use.

How we got here

In June 2017, the Alternative Reference Rate Committee (ARRC) announced the choice of Secured Overnight Funding Rate (SOFR) as its recommended alternative to LIBOR. SOFR is a transacted rate referencing a deeply traded repo market. The immediate concern around this choice was that LIBOR was a term rate (with 1M and 3M terms being the most commonly used) while SOFR was an overnight rate. To address these concerns, the ARRC’s “Second Report” in 2018 provided the following guidance:

The ARRC also stated that a forward-looking term rate’s publication depended on having sufficient depth in the SOFR Derivatives market. Despite this caveat, most market participants expected that a forward-looking SOFR term rate would eventually emerge.

However, in March 2021, the ARRC provided the following update:

This announcement was not a complete surprise to participants who had been watching the volume of SOFR derivatives (especially the short end of the curve) increase too slowly to provide assurances of a robust implied forward rate. Nonetheless, the announcement took several players aback, putting the onus back on market participants to calculate a term rate.

Calculating a SOFR term rate is not simple

There are many decisions to be made before arriving at a calculated SOFR term rate. The major decisions are:

• Methodology to average daily overnight rates to a term rate – simple interest or compounded interest. Note, compounded interest is technically the correct approach but is also more challenging to implement.
• Calculation of the rate “in advance” (start of the interest period) or “in arrears” (end of the interest period). Note that the majority of the cash products referencing LIBOR have had rates set in advance.
• Rollover options for differences between “in advance” and “in arrears.” For participants that set SOFR in advance only to see realized rates during the interest period diverge, there are options to roll over the difference to either the interest payment or principal.

If a participant chooses an in-arrears calculation, there are options to provide a payment delay, lookback period, and observation shift to operationalize invoicing and interest payments. All of these options are laid out comprehensively in the ARRC’s User’s guide and technical appendices.

In addition to the calculations, the ARRC has recommended different variants of the SOFR Term rate for different products, as depicted in the figure below.

Decision for participants

So, where does this leave participants? Abelian Partners has had several conversations with practitioners in US Banks. Broadly, these banks have fallen along the following lines:

• Ready to offer SOFR loans in Q3, 2021. The necessary implementation work is done; however, these banks worry about borrower reactions.
• Avoid SOFR unless necessary. These banks have chosen to go with Prime or AMERIBOR as a default index, with possible exceptions for floating rate loans that need to be hedged. Implementation is ongoing and expected to conclude shortly.
• Waiting on market consensus to emerge. Smaller banks that use Prime as a default are betting on being a nimble, fast follower for wherever the market settles.

Conclusion

The lack of a forward-looking SOFR term rate has complicated efforts to transition away from LIBOR to SOFR. In the absence of a robust alternative to SOFR developing before the year-end, banks will have to manage the complexities of SOFR and act in a coordinated manner to ensure a successful transition. There is not much time left!