Term SOFR – Moving forward because the demand is real
We have posted quite a few blogs on this subject, notably in May 2022 and April 2022. When these blogs were published, the use cases for Term SOFR very restrictive and are defined by the Term SOFR administrator (CME).
More recently, the ARRC has reconvened the Term Rate Taskforce which was reported in the July 13 Readout. The important aspect of this group’s work is to review certain aspects of the Term SOFR uses as in the Readout:
‘The Term Rate Task Force provided an update on its discussions around term SOFR derivatives. In particular, the Task Force has been discussing participants’ views on issues/questions around term SOFR derivatives and the overnight SOFR/term SOFR basis, including clearing, capital, and accounting considerations. It was noted, however, that the Task Force is distinctly not being reconvened to materially relax the substance of the ARRC’s best practice recommendations regarding scope of use for the term SOFR rate.’
The important word is ‘materially’. This implies some changes to the use cases could be supported and therefore able to be reflected in the CME licensing rules for Term SOFR. Risk magazine has covered this topic only recently (7 July 2022) and has provided insightful perspectives on what additional use cases may address participant requirements while still adhering to the basic ARRC principle of proportionality (i.e., not allowing exponential expansion of the use of Term SOFR to keep the volumes referencing the benchmark in proportion to the underlying transactions used to calculate it).
Current CME licensing
The CME website has the following data for Term SOFR use:
Licenses from the CME are divided into 3 categories:
Category One applies to cash instruments like loans, mortgages, bonds, notes, and money market instruments.
Category Two is necessary for applying Term SOFR as a reference in any derivative product. However, the catch is that the license only covers derivatives that are directly linked to cash instruments which reference Term SOFR.
Category Three is used by specialist providers in products or services they develop and license to external clients. We do not cover this category in the blog as it only applies to service providers.
The licensing for Category Two is quite restrictive, appears to create a one-sided market and excludes potentially compliant uses for Term SOFR. In practice, Category Two requires the derivative to only use reference Term SOFR if it applies to a cash debt exposure.
Why is Category Two restrictive?
Category Two, in practice, only allows for derivatives to be used to swap floating rates (Term SOFR) associated with cash products to fixed rates. In other words, a end user can only pay fixed and receive Term SOFR in a standard interest rate swap because the Term SOFR must be associated with the cash instrument to allow a derivative to reference Term SOFR.
One example where there may be an end-user use for Term SOFR is in a derivative swapping fixed debt coupons for floating USD. SIFMA does publish the corporate bond issuance statistics for USD as summarised in the following table:
The corporate bond market is large and a significant percentage (78 – 91%) issue fixed rate. A proportion of the fixed rate issuers may decide to swap the fixed coupons to SOFR and many of these issuers are possibly in a similar operational position to the issuers of floating bonds who are permitted to use Term SOFR.
However, the fixed rate issuers cannot access Term SOFR in the swap to achieve a floating rate liability as it is not allowed in CME Category Two licenses.
Is there any real difference between the floating rate and fixed rate issuers? Arguably there is no difference except the preference of investors at a specific time.
Perhaps there is a legitimate use case for corporate fixed rate issuers to use derivatives to swap to Term SOFR and therefore an amendment to the CME Category 2 licence may be appreciated to allow a fixed to term SOFR swap.
The challenge for the ARRC and the Term Rate Taskforce
The Term Rate Taskforce has been reconvened to consider changes to the recommended use of Term SOFR given how the market has evolved since 2021. (I very much respect their challenges in finding a way to balance the proportionality with clear end-user demand!)
One advantage of allowing for derivatives which swap fixed to Term SOFR is that it helps balance the current market where only Term SOFR to fixed rate is, in practice, permitted. This could remove or reduce the current additional costs of around 1.5 to 3.5 basis points for end user borrowers in referencing Term SOFR (see the Risk article above). I do note that investors could provide the balancing side of the swap, but they could just as easily buy floating rate products (as they seem to be doing in 2022!)
Should the use cases be expanded to allow for derivatives such as the example above?
Should there be inter-dealer trading (perhaps with some restrictions) to allow banks to clear risk and provide more competitive pricing for their customers?
We will have to await the outcomes from the ARRC, but the market is showing there is demand for a less restrictive approach to Term SOFR which would need to be reflected in the CME licensing arrangements.
Summary
While we have written blogs previously on this topic, markets have changed considerably, and the tensions are very clear. The Term SOFR derivatives market is currently one-way as reflected in the basis cost of swapping floating for fixed rate.
Allowing a more balanced market where end-users can have equivalent access to fixed to floating as well as floating to fixed swaps may address some of the pricing imbalances and also provide bank customers a more complete service.
If there is a (limited) inter-dealer market then risk can be cleared more readily and banks can move the Term SOFR exposures to their trading books, thereby reducing operational and capital costs.
There is a compelling argument that end users of Term SOFR derivatives would benefit from some adjustments to the ARRC-recommended use of Term SOFR.
I hope the ARRC can adapt the recommended uses for Term SOFR and that this will be quickly incorporated into the CME Category Two licensing.