June 8, 2021, was an eventful day in the LIBOR transition. That morning, the Interest Rate Benchmark Reform Subcommittee of the Market Risk Advisory Committee (MRAC) of the Commodity Futures Trading Commission (CFTC) announced its recommendation that starting July 26, 2021, interdealer brokers should replace trading of LIBOR linear swaps with trading of SOFR linear swaps. That same morning, the Alternative Reference Rates Committee of the New York Federal Reserve (ARRC) praised the MRAC recommendation and announced that once the switch occurs, it will be in a position to recommend CME SOFR term rates "very shortly thereafter." June 8 also happened to be the date of the ARRC's planned SOFR Symposium. Regulatory speakers at the symposium were confident that the July 26 date for the switch was realistic and achievable. ARRC Chair Tom Wipf clarified that he expects "very shortly thereafter" to mean "days, not weeks."
It's a stunning reversal in what otherwise appeared to be a dim future for Term SOFR just a few months ago. Originally expected in the first half of 2021, Term SOFR was effectively put on hold by the ARRC on March 23, 2021, with its announcement that it would not be in a position to recommend Term SOFR by mid-2021. The key principle announced by the ARRC on April 20, 2021, that Term SOFR should have "a limited scope of use," seemed particularly ominous. The market indicators announced May 6, 2021, which the ARRC indicated it would consider in recommending Term SOFR, gave the market more objective criteria for a path to Term SOFR. On May 21, 2021, the ARRC gave its most hopeful indication that Term SOFR might materialize after all when it announced that it plans to recommend CME Group as the administrator of Term SOFR "once market indicators for the term rate are met." For those trying to read between the lines, the ARRC indications on timing went from "first half of 2021'," to "not mid-2021'," to "don't wait for a term rate," to "relatively soon" to "soon."
Few would have guessed that "not mid-2021" would end up meaning "days after July 26." Although the timing of the MRAC announcement may not have been anticipated, the substance of it is not surprising. The second key principle announced by the ARRC was that there should be "a robust and sustainable base of derivatives transactions." Item 2(b) in the market indicators that the ARRC put out specifically mentions "changing the market convention for quoting USD derivatives contracts from LIBOR to SOFR." As the MRAC noted in its announcement, interdealer trades account for a large percentage of the interest rate swap market. Although the MRAC recommendation does not apply to swaps between dealers and clients, the expectation is that changing the market convention among dealers will put pressure on those transactions to switch as well.
Interestingly, the MRAC called the recommendation "SOFR First." Intentional or not, it gives some insight into what is going on behind the scenes. After much thought and effort by the ARRC and U.S. regulators over several years, the ARRC decided that SOFR is the best replacement for U.S. dollar LIBOR since it is based on trillions of dollars of stable, secured overnight transactions. Market participants may have preferred some sensible changes to LIBOR rather than scrapping it entirely. However, in the context of the 2008 meltdown, the financial stability risk posed by hundreds of trillions of dollars of transactions being based on a thinly traded London market among a handful of banks that was easily subject to manipulation was untenable. SOFR may not be one-size-fits-all, but having chosen SOFR as the best replacement, the ARRC and U.S. regulators are under considerable pressure to push its adoption and defend it against the alternatives.
In this context, the ARRC may not object to a Term SOFR rate as long as it does not hold up the transition to SOFR generally. Simple and compounded SOFR have been operational for some time, but computationally, Term SOFR relies upon a robust SOFR derivatives market, which in turn needs a robust SOFR lending market to drive demand for SOFR derivatives. The hope may have been that there would be enough developments to be able to recommend Term SOFR by the first half of 2021. However, waiting until the end of that period to find out that the goal was still not in sight could have caused market participants to delay further.
Jolting the market as the ARRC did in March may have had two effects. First, it caused lenders to take more definitive steps toward originating SOFR loans. Second, it was a wake-up call to those developing Term SOFR to step up their efforts. The March announcement may have been a bit harsh, but having gotten the market's attention, the ARRC softened the message by guiding the market to the Term SOFR result that the market wanted. It rewarded the market along the way with announcements such as the selection of CME as the proposed administrator of Term SOFR one month after CME went live with the rate, and putting out increasingly optimistic time horizons.
While all of these developments were unfolding, competing rates have been catching up. Ameribor by the American Financial Exchange is garnering a significant following among middle market and regional banks. At the larger banks, the first syndicated credit facility was not a SOFR loan, but based on Bloomberg's BSBY rate. Lenders are generally attracted to these alternative rates since they are based on unsecured transactions reflecting a credit sensitivity closer to the cost-of-funds risks that lenders face compared to what a stable, secured overnight repo market offers. The main difficulty with these rates from the view of regulators and the ARRC is that, similar to LIBOR, they are not based on robust markets (yet). By giving the market the Term SOFR rate that the market wants as quickly as they can, regulators and the ARRC likely hope that they can slow down the adoption of these rates, to the point that they do not pose a significant financial stability risk. In that regard, regulators and the ARRC have not outright said no, but they have become increasingly critical of such alternative rates in recent weeks.
This does not necessarily mean that everything will be smooth sailing from here for Term SOFR. The third key ARRC principle from April 20 is still that Term SOFR should avoid any use that is not in proportion to the depth and transactions in the underlying derivatives market. In its May 21 announcement regarding CME Group, the ARRC noted that it "plans to recommend best practices for the use of the term rate." Combining these two references, the last box on its Term SOFR Checklist, right after the description that market indicators allow the ARRC to recommend Term SOFR, goes on to state that "ARRC recommends best practices for scope of use." The ARRC may have chosen not to advertise that point again in its June 8 announcement so as not to detract from the exuberance of its main message that Term SOFR is almost here. However, there is plenty of warning that the fine print of the final announcement may fall short of complete unfettered use.
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