Is SOFR a strong enough USD LIBOR alternative?

With COVID-19, being declared a pandemic on March 11, 2020, financial institutions have had to shift most of their resources to mitigate the risks that have arisen. This has adversely affected important activities, one of which is market participants’ efforts to detach from LIBOR before its cessation at the end of 2021. As a result, most of the market’s attention continues to focus on two areas regarding the reform. First, is the pandemic’s impact on the already-tight deadlines put in place to boost transition progress, as well as the regulator’s response; second, is the behaviour and robustness of Alternative Risk-Free Rates under a stressed environment. In particular, there are questions on the robustness of the Secured Overnight Financing Rate (SOFR) in relation to USD LIBOR.

SOFR is an overnight rate calculated daily using actual transactions in the wholesale interbank funding market and collateralised by US Treasury Securities. In this respect, SOFR is very different from USD LIBOR, which is an unsecured term rate set by a panel of banks.  LIBOR is not based on actual transactions but rather on the rate that banks are willing to lend to each other, which results in bank credit risk being embedded in the rate’s value. Because of these fundamental differences, it is interesting to compare the behaviour of both rates under the current stressed market environment.

It is the Alternative Reference Rates Committee’s[1](ARRC) opinion that SOFR can be characterised as a robust rate based on several aspects. Amongst others, SOFR is more robust than LIBOR due to its minimal exposure to manipulation based on actual transactions. Furthermore, a rate’s robustness can be assessed on the volatility it depicts during times of stress and its adherence to the economy’s evolution. The adherence to the economy’s movements can be captured by the rate’s co-movement with other money market rates.

Figure 1 below depicts the 3-month USD LIBOR and the 3-month average SOFR. Up until February 2020, the rates have followed a similar trend. However, in March 2020, they moved in opposite directions. USD LIBOR plummeted to a minimum of 0.74% and then started rising aggressively during mid-March. In contrast, SOFR followed a slightly downward trend exhibiting little volatility, as illustrated in Figure 2.

The different movements can be attributed to the credit risk component embedded in USD LIBOR, with the rate’s aggressive rise after mid-March  explained by an increased perceived risk in the banking system. Also, the calculation method of the 3-month average SOFR smooths out volatility, which inhibits strong fluctuations. In addition, SOFR seems to be pulled by the FED’s actions. First by the Quantitative Easing (QE) Program whereby the Bank buys Treasury Securities and Mortgage-Backed Securities and, second, is the $500bn offering in overnight repos. This flood of liquidity seems to have driven the SOFR to low levels, which is perhaps not unexpected due to the rate’s link with US overnight repos collateralised by US Treasury Securities.

The average 3-month SOFR appears to be more robust than 3-month LIBOR due to the lower volatility it has exhibited during the crisis so far. Another argument in favour of SOFR’s robustness is the rate’s high correlation with the Effective Federal Funds Rate, as illustrated in Figure 3. SOFR exhibited a slight lag before reaching approximately the same level as the Fed Funds Rate, as shown by the positive spread between the two rates during March. Evidently, the FED’s actions have managed to draw down secured lending and money market fund rates eventually, but not LIBOR. 

The Fed’s intervention substantiates doubts raised earlier in 2020 by a group of mid-size American banks[2] regarding SOFR’s behaviour during a crisis. The banks argued that during a crisis there is an increased demand for overnight liquidity, which would lead to a jump in short-term borrowing rates such as SOFR. This tight relationship between the repurchase market and SOFR was also observed in September when a spike in the repo market led to the rate skyrocketing. The Central Bank’s actions have strongly influenced the rate’s stability during the current crisis, and market participants are wondering whether the Fed would always be needed to keep the rate stable. If that is the case, then is the rate as robust as it seems?

SOFR also has further drawbacks that have not gone unnoticed by market participants. These include the lack of a credit component that could be useful for hedging purposes, as well as the absence of a term structure. To add to this, the liquidity of SOFR-linked markets remains much lower than LIBOR’s. In April 2020 the volume traded in SOFR-linked swaps was 100 times lower than the volume of USD LIBOR-linked ones ($12 bn vs  $1200 bn[3]). 

While it is legitimate to question the robustness of replacement rates such as SOFR, it’s also essential that enough data and liquidity are available to be able to draw firm conclusions. As global economies begin to emerge from the COVID-19 pandemic and banks devote more resources to the transition away from LIBOR, the behaviour and robustness of Alternative Risk-Free Rates will become more evident.

[1] https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/ARRC-faq.pdf

[2] https://www.americanbanker.com/articles/small-banks-tell-fed-its-libor-replacement-doesnt-work-for-them

[3] The LIBOR Transition: Impact of the SOFR Switch on Swaptions, Dr. Ping Sun, Numerix