ARRC Releases FAQs to Build on Efforts to Engage and Educate Market Participants and Other Stakeholders
The Alternative Reference Rates Committee (ARRC) has released a new set of frequently asked questions (FAQs) designed to provide information to the market and broader public about the work of ARRC, its progress to date and the overall effort to promote voluntary market adoption of its recommended alternative to U.S. dollar (USD) LIBOR, the Secured Overnight Financing Rate (SOFR).
The first steps in the Paced Transition Plan, targeted for 2018 and early 2019, are focused on creating a baseline level of liquidity for derivatives contracts referencing SOFR. End users cannot be expected to choose or transition cash products to a benchmark that does not have at least a threshold level of liquidity in derivatives markets required for hedging of interest rate risk.
During the course of the year in 2019, increased trading activity in SOFR-linked futures and OIS markets should foster accumulation of price histories and in turn help market participants develop an understanding of the term-structure dynamics of longer-dated exposures in SOFR. As liquidity develops, as the next step, CCPs are expected to provide their members with a choice of clearing instruments using discounting curves based on SOFR and paying SOFR as interest on collateral posted by the first quarter of 2020. As liquidity in longer-term SOFR derivatives develops further, CCPs would then move to exclusively using SOFR discount curves and paying SOFR as interest on collateral for all new trades.
Once these initial steps of the Paced Transition Plan are successfully accomplished, which is expected in 2021, and liquid derivative markets referencing SOFR have developed, the final step in the Paced Transition Plan calls the creation of a forward-looking term rate based on SOFR-linked derivative markets. Availability of a forward-looking term structure for SOFR may be necessary to transition some cash products from USD LIBOR to SOFR to ensure certainty of cash flows for retail and corporate end users. With the availability of SOFR term rates and liquid derivative markets, it is expected it will be possible to use SOFR for cash products before the end of 2021.
Subsequent to the publication of SOFR on April 3, 2018, there have been a number of notable steps made by the industry in line with the Paced Transition Plan, certain elements of which are now ahead of schedule. These include CME Group successfully launching 1- month and 3-month SOFR futures on May 7, 2018, clearing of SOFR OIS and basis swaps at LCH beginning July 18, 2018, and the announcement that CME Group will clear SOFR swaps in the third quarter of 2018.