Long Live SOFR

The move away from a credit sensitive reference rate implies that credit concerns can now only manifest in price, potentially amplifying volatility during times of financial stress. USD LIBOR will officially be replaced on June month-end by SOFR, a reference rate based on overnight Treasury repo transactions. SOFR is very different from LIBOR in that it is both credit risk free and is not forward looking, though forward looking versions have been calculated using derivatives. This means that investors can no longer be compensated for increasing risk through rising reference rates, but only through mark downs in asset prices. This post introduces SOFR, discusses broad factors that influence its fluctuations, and suggests that its use will amplify financial instability.

Secured Overnight Financing Rate

SOFR is a reference rate published daily by the New York Fed that is calculated from transactions in the overnight Treasury repo market and is well controlled by the Fed. At a high level, Treasury repo is just a secured loan against Treasury collateral. The loan is considered risk free because it is backed by Treasury collateral, and also very short in tenor. The borrowers in the market are largely dealers and hedge funds, and the lenders are largely money market funds and dealers. Treasury repo is a very deep and liquid market with daily transactions in excess of a trillion, so it is robust to the manipulations that allegedly impacted LIBOR. It is also a market that can directly be controlled by the Fed.

The Fed operates as both lender and borrower in the Treasury repo market, so it can effectively police SOFR to remain within any boundary. At the bottom of the range, the Fed puts a floor on SOFR by willing to borrow virtually unlimited amounts of cash at the RRP offering rate. At the top of the range, the Fed is willing to lend in repo to certain market participants using its relatively new Standing Repo Facility. The ability to fully control SOFR sets the stage for an eventual shift away from the obsolete Federal Funds Rate towards SOFR as the official policy rate. Note that changes to SOFR are impactful but do not always fully flow through to other money market rates.

Policy and Plumbing

The primary determiniant of SOFR levels are Fed actions, but SOFR can also fluctuate according to supply and demand dynamics in the the money market space. A big supply of cash into money markets can push SOFR lower, and increased demand for money market financing can push SOFR higher. Recently, money market fund assets have swelled to record levels and left many MMFs with no choice but to invest in the Fed’s RRP facility. This places downward pressure on SOFR as MMFs will withdraw money from the RRP and invest in private repo the moment private repo rates rise above the RRP offering rate.

An increase in demand for money market financing from borrowers like hedge funds, the U.S. Treasury or Federal Home Loan Banks can push SOFR higher in the target range. In early 2018, a surge T-bill issuance led to a rise in SOFR as repo borrowers competed against Treasury for financing by offering higher repo rates. In 2019 and more recently, hedge funds significantly increased their repo borrowings as they put on cash-futures basis trades. The increased demand for repo financing in 2019 drove repo rates steadily higher and even above interest on reserves.

Price Release Valve

SOFR appears to improve policy transmission, but it would merely shift prior basis widening to asset price declines. While LIBOR would rise to reflect rising credit risk faced by investors, SOFR has no credit component and may actually decline during risk events as the Fed cuts rates or investors seek shelter in money market funds. In March 2020, SOFR fell rapidly due to rate cuts even as LIBOR continued to rise to reflect market stress. An investor holding LIBOR linked assets would have earned higher interest to compensate him for increasing credit risk, but someone holding SOFR linked assets would have preversely earned less interest for more risk.

The shift to SOFR potentially increases the volatility of assets during a downtown as investors would need to rapidly mark down the prices of SOFR linked assets to properly reflect increased credit risk. The official sector recommends legacy LIBOR contracts to be tranisitioned to SOFR plus a small credit spread calculated on 5 years of historical data. The recommend spreads are very small, especially as credit risk as proxied by LIBOR-OIS has widened to hundreds of basis points during times of significant stress. In the future that same degree of risk could only be expressed by significant declines in asset prices.

Source: Alternative Reference Rate Committee