Understanding SOFR: The New Benchmark for Global Credit Markets

On June 13, 2023 By  Awake-In-3D

Is the transition to the SOFR interest rate benchmark going to push the proverbial button on the RV/GCR? It seems that nearly every event in the financial economy these days is labeled as a “the trigger” for Our GCR. This is simply not the case. My regular readers know my position on Our GCR release being the collapse of the current Fiat Currency System. Consequently, I view volatile economic and financial events as falling dominoes in the inevitable fiat debt system implosion. As the financial industry rushes to meet the June 30th (2023) transition deadline from LIBOR to SOFR-based interest rates, it may further increase default risks for banks but it is not a GCR trigger event.

So let’s become factually familiar with SOFR and what may lie ahead for the current financial system landscape.

Introduction

The global credit markets are undergoing a major shift as the industry moves away from the London Interbank Offered Rate (LIBOR), the benchmark for interest rates for decades. The replacement for LIBOR is the Secured Overnight Financing Rate (SOFR), a benchmark that was introduced by the Federal Reserve Bank of New York in 2018.

What is SOFR?

SOFR is an interest rate benchmark that is calculated based on transactions in the U.S. Treasury repurchase market. The rate is derived from the cost of borrowing cash overnight, collateralized by U.S. Treasury securities. It is a risk-free rate that reflects the cost of overnight borrowing in the U.S. Treasury market. SOFR is calculated and published daily by the Federal Reserve Bank of New York, and it is intended to replace LIBOR as the primary benchmark for short-term interest rates.

Why is SOFR Important?

LIBOR has been the primary benchmark for interest rates for decades, but the rate has been plagued with issues. The benchmark has been subject to manipulation, and the market that underpins it has dwindled, making it increasingly difficult to calculate. In addition, the Financial Stability Oversight Council (FSOC) in the United States has raised concerns about the potential systemic risk posed by LIBOR’s discontinuation. These concerns prompted the industry to explore alternative benchmarks, and SOFR emerged as the leading candidate.

SOFR is a more reliable and transparent benchmark than LIBOR. It is based on actual transactions in the U.S. Treasury repo market, which is a much larger and more liquid market than the interbank market that underpins LIBOR. SOFR is also less susceptible to manipulation since it is based on observable market prices rather than estimates submitted by banks. As a result, SOFR is expected to be a more accurate reflection of the underlying cost of borrowing.

The Impact of SOFR on the Global Credit Markets

The transition from LIBOR to SOFR is expected to have a significant impact on the global credit markets. The shift will affect a wide range of financial products, including bonds, loans, and derivatives. The transition is expected to be particularly challenging for legacy contracts that reference LIBOR and do not have fallback provisions. These contracts will need to be amended to include fallback language that specifies an alternative benchmark if LIBOR is discontinued.

The shift to SOFR is also expected to require changes to the infrastructure that supports the credit markets. Market participants will need to modify their systems and processes to accommodate SOFR, and new products and services will need to be developed to support the new benchmark. The industry is already working on developing new products and services that are based on SOFR, including SOFR-based futures and options and SOFR-linked bonds.

The Impact of SOFR on Borrowers and Lenders

The shift to SOFR is expected to have an impact on both borrowers and lenders. Borrowers may see changes in the pricing of their loans, as SOFR is generally expected to be lower than LIBOR. This could result in lower borrowing costs for some borrowers, particularly those with floating rate debt. However, borrowers may also face increased costs associated with amending legacy contracts to include fallback provisions.

Lenders, on the other hand, may see changes in their funding costs. Since SOFR is a risk-free rate, lenders may need to adjust their pricing to reflect the lower risk associated with SOFR-based loans. Lenders may also face increased costs associated with modifying their systems and processes to accommodate SOFR.

The Transition to SOFR

The transition from LIBOR to SOFR is a complicated process that requires significant coordination among market participants. The Alternative Reference Rates Committee (ARRC) in the United States has been leading the effort to transition to SOFR, and it has developed a set of recommended best practices for market participants to follow.

One of the key challenges of the transition is the need to amend legacy contracts that reference LIBOR. The ARRC has recommended that market participants include fallback language in these contracts that specifies an alternative benchmark when LIBOR is discontinued.

Another challenge of the transition is the need to modify the infrastructure that supports the credit markets. Market participants will need to modify their systems and processes to accommodate SOFR, and new products and services will need to be developed to support the new benchmark.

SOFR May Place Increased Stress on Already Stressed Banks

The switch from LIBOR to SOFR as the new benchmark rate has raised concerns about the potential negative impact on bank balance sheets during times of financial stress. The effective demise of the tainted London Interbank Offered Rate (LIBOR) this month and the switch to the risk-free Secured Overnight Funding Rate (SOFR) has renewed concerns about the impact of the new measure on banks.

The transition to SOFR has been well-telegraphed for years and US banks are mostly prepared for the new rate regime. However, LIBOR’s permanent shutdown on June 30 comes on the heels of a destabilizing outflow of deposits at the nation’s mid-tier banks.

While US banks are mostly prepared for the new rate regime, the effective demise of LIBOR and recent outflow of deposits at mid-tier banks has heightened concerns about the transition. One main concern is that SOFR has no credit component and tends to fall during financial crises, which could hurt banks’ balance sheets and constrain lending to the broader economy.

This was highlighted by the New York Fed in a study released in December 2022. “Banks are going to be more exposed with SOFR lines of revolving credit because borrowers, in a crisis, will be able to borrow at a very low rate (when SOFR rates goes down),” said Darrell Duffie, professor of finance at the Stanford Graduate School of Business and a co-author of the New York Fed study. “When corporations borrow under revolving lines of credit at a low rate during a crisis, the banks will have to fund those borrowings at a time when bank funding costs are going way up,” he added.

In 2019, several regional banks sent a letter to US regulators, warning that the transition to SOFR could adversely affect loan extension. The assumption was that if SOFR falls, commercial borrowers would tend to hoard liquidity by drawing on their lines of credit. Revolving lines of credit make up the largest share of bank lending to corporations at 59%, Duffie said.

The New York Fed study concluded that the transition to SOFR may have implications for bank funding costs and balance sheets, especially in times of stress. “While SOFR is a more robust and transparent rate than LIBOR, it may be more sensitive to changes in market conditions,” the report said.

Despite these concerns, some analysts argue that the benefits of switching to SOFR outweigh the risks. SOFR is considered a more reliable benchmark rate than LIBOR, which was tainted by manipulation scandals. The switch to SOFR is also expected to reduce systemic risk in the financial system.

Conclusion

The transition from LIBOR to SOFR has raised concerns about the potential negative impact on bank balance sheets during times of financial stress. While SOFR is a more reliable benchmark rate than LIBOR, it has no credit component and tends to fall during financial crises, which could hurt banks’ balance sheets and constrain lending to the broader economy. However, regulators have been working closely with banks to ensure a smooth transition, and many banks have already started using SOFR in transactions. The benefits of switching to SOFR are, according to the “experts”, expected to outweigh the risks, and the switch is also expected to reduce systemic risk in the financial system … Maybe

https://ai3d.blog/understanding-sofr-the-new-benchmark-for-global-credit-markets/