Today marks a significant day in banking history as it is one of the few times that the interest rate market has seen the creation of a new index. No doubt you have heard about the theoretical phasing out of the Libor Index after 2021 and the transition to the Secured Overnight Funding Rate (“SOFR”). With approximately $200 trillion in volume, Libor is one of the largest financial indices in the world. In this article, we look at this newly published rate and discuss some ways that banks can best prepare for this potential transition. In addition, we also give you our proposed language for your loan documents and participations that will hopefully save your counsel drafting time.
Here is the Very First SOFR Rate
The SOFR benchmark is expected to be published daily at 8:30 a.m. ET, based on the prior day’s trading activity. Today is the first time this rate has ever been officially published and SOFR was set at 1.80% compared to the Fed Funds Effective Rate at 1.67% and the 1-Month Libor at 1.88%.
Here is the link that you might want to keep handy so that you can reference it in the future - https://apps.newyorkfed.org/markets/autorates/sofr
What Is SOFR?
For decades, Libor (formally also known as the British Bankers Association Libor) has provided a stable way to price everything from term borrowings between central banks, residential mortgages, student loans, commercial real estate loans and complex derivatives. Libor is an administrated rate based on input from 20 banks on where they would lend to each other without collateral. The problem arose that during the last crisis, these 20 banks had no observable market prices and had to guess. This resulted in not only unvalidated pricing but also in manipulation. Libor was reformed several years ago to be more market-based, and its administration was moved to the Atlanta-based Intercontinental Exchange (ICE).
By contrast, SOFR will be derived only from transacted data with Bank of New York Mellon (BNYM) and the Depository Trust and Clearing Corporation (DTCC) providing transaction-level data for various segments of the repo market. In theory, the pure market-based nature of SOFR will make it more accurate and much less prone to manipulation.
Where Libor is the benchmark rate that banks and other financial institutions trade funds unsecured, SOFR is an index composed of a portion of the existing repo market. Repo, unlike Fed Funds trades and other short-term interbank borrowings, is done with a standard contract with highly marketable securities as collateral. This makes SOFR almost risk free and as a result, lower than a comparative Libor rate.
SOFR will start with an aggregation of existing overnight repo transactions and then expand out into term starting with one week and then expand out to 12 months.
While the above is likely all you ever have to know about SOFR construction, we want to go one level deeper. Our logic is that one day you will meet that sophisticated borrower, regulator or board member that has capital markets experience and will ask more detailed questions and we suggest bookmarking this blog for future reference.
Here is More Than You Want To Know
SOFR will be where “tri-party” (two parties plus a collateral agent) and bilateral (just two parties with no collateral agent) repo clears the market (matched buyers and sellers). This includes all General Collateral Finance (GCF) repo, Fixed Income Clearing Corporation (FICC) cleared bilateral repo, and BNYM Tri-party overnight repo. The GCF data provided by DTCC will be matched off against the FICC data and reported as a single transaction thereby giving a measure of validation. FICC-cleared bilateral repo data reported by the DFTCC will filter out transactions below the 25th percentile to minimize the impact of “specials” activity. This is called using “trimming methodology” and means that some repo trades that have higher or lower than general market prices due to the value of specific collateral such as a repo against a particular 10-Year Treasury Note will be excluded in the index calculations. The elimination of these special trades will present a more stable index for all market participants. Also, all repos between Wall Street and the Federal Reserve will be excluded as will non-cleared bilateral repo.
You now have more information about SOFR than 90% of the market and you should be able to hold your own with all but the most experienced Wall Street repo traders.
Loan Documentation Language
We don't give legal advice, but in case you need a starting point, below is sample language that, after review and approval by your counsel (we provide for “edutainment” purposes only), you might consider using in loan documents, participations and other instruments to prepare for the future. This will make your documents more flexible and will prepare your bank for a potential transition.
Here is some language to consider for your loan documentation:
“The Interest Rate on this Note is subject to change from time to time based on changes in an independent index which is the per annum rate that major banks charge for deposits in U.S. dollars to other major banks. This interbank market rate will be for a period equal to one (1) month that appears from time to time on the “LIBOR BBA US$ Fixing” screen available electronically from Bloomberg Financial Markets Information Services (the “Index”). The Index is not necessarily the lowest rate charged by Lender on its loans. If the Index becomes unavailable during the term of the Loan, Lender may designate a substitute Index after notifying Borrower.”
In addition to your loan documentation, here is some sample language to consider for participation agreements:
“Changes to, or Elimination of, LIBOR Could Adversely Affect This Participation.
The Federal Reserve’s Alternative Reference Rates Committee (“ARRC”) announced its intention to cease sustaining LIBOR after 2021. The ARRC indicated that it does not intend to sustain LIBOR through using its influence or legal powers beyond that date. It is possible that ICE and the panel banks could continue to produce LIBOR on the current basis after 2021, if they are willing and able to do so, but we cannot assure you that LIBOR will survive in its current form, or at all. In the event ICE ceases to set or publish a rate for LIBOR, or LIBOR ceases to be, in our opinion, a representative market rate, we will select an alternative index. If, prior to the time that ICE may cease to set or publish a rate for LIBOR, a new industry standard index is adopted, we may elect, in our sole discretion, to use such standard index in lieu of LIBOR. We cannot predict the effect of the ARRC’s decision not to sustain LIBOR, or if changes are ultimately made to LIBOR, the effect of those changes. In addition, we cannot predict what alternative index would be chosen should this occur. If LIBOR in its current form does not survive or if an alternative index is chosen, the market value of this Participation could be adversely affected.”
It is an extremely rare event to have a birth of a new index that will grow up to compete with existing indices for the same attention and liquidity. A lot has to happen before SOFR becomes usable for banks, namely a liquid futures market must be established and then that market has to be robust enough to trade twenty and thirty-year instruments. It is a tall order and one that we are not 100% convinced that this can happen by 2021.
Starting with today, here is our best guess at a timeline for conversion from Libor to SOFR.
Putting This Into Action
Every senior banker should have a working knowledge of what is happening with Libor and SOFR. It is not only a rare event in the financial markets and the subject of many professional cocktail parties, but a question comes up once per month on SOFR that we have to answer. Borrowers, shareholders, analysts, regulators, reporters, lawyers, and auditors have and will continue to question bankers. For the sake of professionalism, it helps if you can have ready answers. Hopefully, this article can help serve as a reference guide to educate your team and your board.
At present, Libor is doing its job, and like any incumbent, will be hard to replace. However, over the next year, we will be watching the depth of the futures market and how this develops for further insight. Until then, bankers should discuss and formulate a plan on how a transition might look. We believe that over the next ten years SOFR will be the dominate index for liquidity trades, loans, securities, and derivatives. SOFR, we expect, will emerge as the superior index on which to benchmark all bank assets and liabilities.
Submitted by Chris Nichols on April 03, 2018