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Benchmark surge: the perfect storm

When Euromoney was researching a feature in August on the market’s transition away from Libor, one portfolio manager was keen to impress upon us the importance of the fact that the US replacement rate (Sofr – secured overnight financing rate) is reliant on repo.

“The repo rate is very different from Libor,” he told us. “It solves the issue of having robust underlying market data, but it behaves differently to Libor and the market needs to learn how it behaves.

“There are spikes, but the Fed can introduce tools to reduce volatility such as a repo facility. The Fed is very much aware of this. But – in and of itself – Sofr will be more volatile.”

His words were still ringing in our ears on September 17, when the Sofr rate shot up from 2.43% to 5.25%.

Perfect storm

This ‘Sofr surge’ was the result of a perfect storm: an upcoming corporate tax payment date, the issuance of more than $100 billion-worth of investment-grade debt that had drained repo markets to fund inventories at the broker dealers, and $60 billion of Treasury bond maturities that had negatively impacted available cash.

The Fed had been unable to intervene to stabilize the overnight rate, which added to the problem.

These conditions, which had caused Sofr to move 282 basis points, had produced a mere 4bp move in overnight dollar Libor, a 1bp move in one-month US dollar Libor and a 2bp move in three-month US dollar Libor.

This is not just material in the world of interest-rate pricing, but of huge economic impact 

 – Shearman & Sterling

It is not the first time this kind of spike has happened: on the last day of 2018, Sofr shot up 147% to an intraday peak of 7.25%.

The Alternative Reference Rates Committee (ARRC), which is managing the transition away from US dollar Libor, was quick to emphasise that the new benchmark uses an average of overnight rates that is smoothed out over time, so Sofr had risen just 2bp if viewed over a 90-day period. The rate was back down to 1.86% by September 20.

However, the episode has unsettled a market already nervous over the breakneck timetable for transition to the new rate.

‘Huge economic impact’

The backward-looking, cumulative nature of Sofr could amplify the impact of such surges.

As term rates are based upon actual Sofr overnight rate data, lawyers at Shearman & Sterling point out that the one-month Sofr rate – onto which the derivative markets are being encouraged to transition – would continue to capture and incorporate the effects of the Sofr surge for the following month.

If and when three-month term Sofr rates are published, the same will be true.

“Given the 282bp of surge and assuming this is very short-lived, the increase to the one-month Sofr for each of the 30 days following the Sofr-surge event will be approximately 10bp,” they predicted on September 18.

“This is not just material in the world of interest-rate pricing, but of huge economic impact. For those who are interest-rate traders, this Sofr-surge event presents a material change for risk-management purposes and complicates managing a complex book of interest-rate positions.”

The transition from forward-looking Libor to backward-looking Sofr was always going to be a steep learning curve in the differences between the two, but dealing with Sofr spikes of this magnitude only serve to emphasise just how steep and treacherous that curve might turn out to be.

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