Short-Term Reference Rates at a Crossroads

18/05/2021

Jerome Schneider, Marc Seidner, Rick Chan, Tiffany Wilding

Market participants have been hesitant to accept SOFR as the successor to Libor, but uniting around a single reference rate is increasingly important to keep benchmark markets from becoming fragmented.

As U.S. financial markets prepare to abandon the London interbank offered rate (Libor) and move toward a new short-term benchmark, there has been renewed discussion – and recently signs of division – about the next appropriate reference rate.

This transition is being driven by a need to replace Libor, a global standard in lending markets that was found to be subject to manipulation. That manipulation caused regulators worldwide to pursue more reliable alternatives. In the U.S., the Federal Reserve has called for new contracts based on Libor to be phased out by year-end, and existing ones transitioned by June 2023.

The Alternative Reference Rate Committee (ARRC), a group of market participants convened by the Federal Reserve Board and the New York Fed, has recommended the secured overnight financing rate (SOFR) to replace Libor, given its transparency and observable daily transactions. Despite that endorsement, market actors have been hesitant to adopt the SOFR index in cash and derivative markets. As such, in recent weeks some segments of the market have experimented with alternatives to SOFR that might serve as replacement benchmark rates.

Time is critical, and we believe market participants, administrators, and regulators need to coalesce around a single benchmark to create the depth and reference point necessary for indexing short-term rates. A standardized reference rate is essential to support efficient and transparent distribution of credit to the real economy through consumer and corporate credit. Without decisive action and widespread support, markets will become less liquid, and potentially less efficient, with possible real-world implications.

Credit component

A key difference between SOFR and Libor relates to credit risk. SOFR is conceived of as a “risk-free” rate that measures the cost of borrowing cash overnight collateralized by U.S. Treasury securities using Treasury repurchase agreement (repo) market data. Libor is an estimate of the average interest rate banks would charge another bank for an unsecured loan over a particular period.

Benchmarks that are credit-sensitive can appeal to banks because they’re similar to Libor, may work better with current systems, and – as they’re higher than risk-free rates – can provide more cushion for yields when rates decline.

Credit-sensitive alternatives to SOFR have emerged, including the Bloomberg Short-Term Bank Yield Index (BSBY) and Ameribor. Late April saw the first debt issuance linked to BSBY – a $1 billion, six-month deal by Bank of America – and the trading of the first BSBY-SOFR index swap. Furthermore, statements in April by S&P and Fitch signaling that BSBY satisfies the criteria for benchmarks set by the credit rating companies provide additional justification for investors to look beyond SOFR as the only alternative to Libor.

SOFR stagnates

Meanwhile, issuance of SOFR-linked products has ebbed, and volumes of related derivatives have been less than robust. Derivatives marketplace CME in April said it will publish one-, three- and six-month term SOFR reference rates, but the ARRC – which initially planned to implement a term SOFR structure in June – delayed its own timetable because the market lacked the needed depth.

ARRC’s efforts seemingly have not done enough to encourage usage of SOFR, even as the sunset for Libor looms, and there’s a need to consider all relevant alternatives. We believe there needs to be clear requirements for any benchmark for markets to successfully move away from Libor. Those include the following:

The benchmark cannot be manipulated
The benchmark must be able to be modeled and analyzed
The benchmark must be executable in depth
An active derivative market must exist

The key, in our view, is not to attempt to engineer the perfect rate, but rather to adapt to a new benchmark that offers investors efficient and accurate ways to manage interest-rate exposures. There are implications for financial markets and the real economy, including diminished liquidity and increased transaction costs, the longer the current signs of fragmentation persist.

For more on what the Libor transition means for markets, read our Understanding Investing article, “The Market Transition Away From Libor ” and our blog post, “Treasury Issuance Could Aid Adoption of SOFR Benchmark ”.

Jerome Schneider is a managing director and leads short-term portfolio management at PIMCO. Marc Seidner is CIO non-traditional strategies. Rick Chan is a portfolio manager focusing on global macro strategies and relative value trading in interest rates. Tiffany Wildingis a PIMCO economist focused on North America. All are contributors to the PIMCO blog.