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Forward-Looking Forward Rates: The Term SOFR Paradoxes

Companies and Markets

By Xi (Figo) Liu, CFA  |  November 30, 2021

In 2017, the Alternative Reference Rate Committee (ARRC) chose the Secured Overnight Financing Rate (SOFR) as the replacement for USD LIBOR. Since this announcement, the LIBOR transition has been making steady progress. As part of this transition, term SOFR has been requested by market participants so that it can be referenced in financial contracts in the same way as LIBOR term rates.

Initially, the proposed scope of usage for term SOFR was limited and discouraged. However, as the market evolved, it allowed for term SOFR to potentially be referenced more broadly than originally designed. With a wider scope of usage, it is worth discussing the issues that could arise with term SOFR. Our research highlights three paradoxes of term SOFR:

  • The publication of the derivative-inferred term SOFR does not meet the transparency requirement and creates modeling complexities and unwanted one-way dependency between the derivative and cash markets
  • Adopting term SOFR will create challenges for operational risk management, and potential instability for financial markets
  • Hedging term-SOFR-based instruments will be inefficient and cost-ineffective for all term SOFR users

What is Term SOFR?

Fixed-income instruments such as floating rate notes (FRN), loans, and mortgages are typically linked to a term rate on a tenor of 1, 3, 6, or 12 months. Because SOFR is an overnight rate, it needs to be compounded daily to get an equivalent term rate. This term rate is expected to serve the same role as the term LIBOR fixing rate. Term SOFR represents an indication of the forward-looking measurement of overnight SOFR, based on market expectations implied from derivative markets.

Recently, the ARRC selected CME Group as the administrator of the forward-looking term SOFR, following the completion of a key change in interdealer trading conventions on July 26, 2021, under SOFR First. This completed the final step of the paced LIBOR transition plan. The SOFR term rate is the third term risk-free rate that has a dedicated administrator, following term SONIA, and the Tokyo term risk-free rate (TORF). The CME Group has published the CME Term SOFR Reference Rates Benchmark Methodology document for reference.

Chicken or the Egg: The Term SOFR Paradoxes

Term SOFR is different from the soon-to-be-retired LIBOR rate, not only due to the representation of the financing costs behind it, but also due to the way it gets published. The different publication method is the major reason why it creates three major paradoxes in what the LIBOR transition intends to achieve.

  1. An “engineered” benchmark rate is prone to complex methodology, data failure, partial representation of the market expectations, and market manipulations. Since the term SOFR rate relies on SOFR futures under the ARRC-endorsed methodology, a complex interest rate curve construction methodology is required, which adds model risk. It also demands more liquidity to satisfy the requirements that the future prices be representative of the market and available at all times. Relying solely on futures market data biases other instruments such as the cash market, which may have totally different expectations inferred from the prices. Unlike the LIBOR benchmarks that can serve both derivative and cash products, term SOFR rates create an unwanted one-way dependency between the derivative and cash markets. In extreme circumstances, this could reduce the diversification effect of a portfolio and add systematic risk. Even worse, since the benchmark rate is “engineered,” people can “re-engineer” products to impact the published rate.
  2. Ineffective hedging with the current market setup. Without term-SOFR-based derivatives, hedging term SOFR cash products can be ineffective and inaccurate. Since the term SOFR rate is “engineered,” the exact process to re-engineer it is required for exact hedging, which is almost impossible. Hedging with other SOFR-based derivatives works but basis risk is inevitable. A portfolio immunization strategy can be only partially achieved, and a cash flow matching strategy is impossible. This creates even more trouble for lenders and corporate issuers compared to the LIBOR era. Although term-SOFR-based derivatives may be allowed for hedging purposes in the future, it poses another challenge for regulators to enforce the rules.
  3. Term SOFR can be unrepresentative or even not published on time due to the mechanics of how it is created. How the market will react to these events is unknown; however, this could potentially create financial system instability or raise doubts about the accuracy of the data. In the end, the LIBOR problems are not gone but instead become worse.

If Not Term SOFR, What Happens Next?

It is imperative to reduce the complexity of the methodology to derive term SOFR, and to break the one-way dependency that is embedded in adopting the methodology. Improving the publication methodology of term SOFR is one possible solution but may be too difficult an ask. Instead, other benchmarks could emerge on the term rate scope if they can resolve the issues highlighted above. The market can easily welcome SOFR being dominant in the overnight market but multiple other benchmarks being popular in the term market.

What Should LIBOR Users Do?

Anyone holding LIBOR-linked securities, which will be falling back to term-SOFR-linked securities, or newly issued term-SOFR-linked securities, should be aware of the possible issues with this benchmark rate. Due to the underlying issues, corporate issuers may decide to call back the securities earlier than expected, without justification. A hedged portfolio may begin to exhibit basis error and inaccuracy. Depending on the type of firm, it may be a good time now to seek advice/service on more accurate hedging such as initializing term SOFR derivatives within the legal scope. Firm should also consider switching off legacy LIBOR contracts to SOFR contracts, or at least conducting a thorough analysis of the performance and risk of term-SOFR exposures.

Yudi Bai, Senior Financial Engineer at FactSet, also contributed to this article.

This article is related to a longer form article titled Term Risk Free Rates: Methodologies, Challenges, and Future that is being published in The Journal of Derivatives in the spring of 2022.

The information contained in this article is not investment advice. FactSet does not endorse or recommend any investments and assumes no liability for any consequence relating directly or indirectly to any action or inaction taken based on the information contained in this article.

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Xi (Figo) Liu, CFA

Associate Director, Lead Financial Engineer

Mr. Xi (Figo) Liu is Associate Director, Lead Financial Engineer at FactSet. In this role he conducts research and development for FactSet’s fixed-income product suite. Mr. Liu earned a master’s degree in Mathematical Finance from the Illinois Institute of Technology and a BS in Finance from the Southwestern University of Finance and Economics in China. He is a CFA charterholder.

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