The SOFR Transition: Benchmarks, Futures and P&L
Finadium
October 2018
The issues and challenges associated with moving away from LIBOR – what has been called “the most important number in the world” – are complex. And the market has until the end of 2021 to get it all done. The good news is that regulators, dealers, and investors know this is coming and what the successor benchmarks will be. But the real work is just starting and there is no guarantee that the cure won’t be worse than the disease.
In the US, the Alternative Reference Rates Committee (ARRC) has chosen the Secured Overnight Financing Rate (SOFR) to replace LIBOR. This new rate is based on executed repo transactions, as opposed to unsecured and often hypothetical observations contributed by major dealers. An active transition to SOFR is underway, with new bond issues tied to the benchmark and market infrastructure gearing up to handle the change.
This paper examines a number of aspects of the SOFR transition. SOFR is an overnight secured rate while LIBOR is an unsecured term rate. LIBOR, in the form of Eurodollar futures, has a deep futures market with transparent forward curves. SOFR has a brand new futures market with volume too low to reliably create much of a forward curve. Hundreds of trillions of notional dollars of derivatives are indexed from LIBOR but barely anything yet on SOFR. SOFR is growing fast however and will be unavoidable. As with many concerns in financial markets, the big one here is who will make or lose money in the transition?
This report should be read by financial market participants working to transition away from LIBOR to SOFR. While it has been written with securities finance and collateral management professionals in mind, the history and future prospects of US rate benchmarks have implications for a broad cross-section of the market.
Table of Contents
- Executive Summary
- The Rise of SOFR
- Evaluating the Mechanics
- – Is SOFR a Better Mousetrap?
- – SOFR and the Effective Federal Funds Rate
- Managing the Pricing Transition
- – Pricing the LIBOR to SOFR Spread
- – LIBOR Fights Back
- – A Lesson from the Move to Eurodollar Futures
- SOFR Futures: A Critical Component
- – Non-derivatives that Reference LIBOR
- Next Steps and Loose Ends
- About the Authors
- About Finadium LLC