Term SOFR or not Term SOFR
My last paper made the case for the wider use of Term SOFR. My argument was based on the fact that the potential users of Term SOFR would only occupy approximately 1% of USD derivative turnover and would, therefore, hardly represent a systemic risk. Wider Term SOFR use, together with robust fallbacks, could significantly ease the operational risk and pressures on the end-users, i.e., the counterparties paying spreads to dealers.
On 21 April 2023, ARRC published ‘Summary and Update of the ARRC’s Term SOFR Scope of Use Best Practice Recommendations’ which reiterated and described their approach to the use of Term SOFR. The ARRC continues to recommend the restrictions on the use of Term SOFR which are reflected in the CME license agreement (CME is the administrator of the most commonly referenced Term SOFR).
The current restrictions will most likely continue to support the basis between Term SOFR and compounded SOFR, specifically Term SOFR is around 3 basis points above compounded SOFR for term (say 5 year) derivatives. This is because the restrictions encourage a one-way derivatives market where users can only pay Term SOFR but are restricted from receiving Term SOFR.
This paper looks at some alternatives to Term SOFR which may help end-users achieve the outcomes of Term SOFR without referencing Term SOFR and potentially offending the CME license conditions.
Let’s start with an example
Clients often have had loans linked to LIBOR and fixed debt issues swapped to LIBOR. The combination of floating and fixed liabilities has been managed using derivatives to the desired mix of LIBOR and fixed rates.
As assets are added or changed, the derivative market was a convenient and efficient way to trade into the desired exposure for the asset/liability balance. But this is about to change as USD LIBOR is discontinued from 30 June 2023. From July 2023 the USD market transition will force market users to alternate reference rates, including compounded SOFR, Term SOFR among others.
In the current system, a loan referencing Term SOFR can be hedged to a fixed rate using a derivative, so in this situation there is essentially no change from the situation faced under LIBOR.
However, using a derivative to swap a fixed rate debt issue to Term SOFR is not encouraged (ARRC recommendations) or permitted (CME license).
This is very clear from Scenario 7 in the ARRC publication reproduced below.
This is a significant change from the LIBOR experience.
The end-user may have a preference for Term SOFR referencing liabilities which is allowed via a loan but cannot be achieved by swapping a fixed rate debt issue to the same Term SOFR. The only way forward is to swap the fixed rate to compounded SOFR and run the basis risk between Term SOFR and compounded SOFR.
This is hardly ideal and potentially introduces new interest rate and operational risk.
Can you manage this risk using a basis swap from SOFR to Term SOFR?
The ARRC recommendations appear to allow this activity. Specifically, Scenario 8 shows the following transaction:
The accompanying commentary seems to imply this activity is permitted but the two scenarios below would not be in the spirit of the ARRC recommendations:
swap fixed coupons to compounded SOFR; then
swap compounded SOFR to Term SOFR (Scenario 8).
This does not appear to be permitted in the CME license as the Term SOFR risk is not embedded in a cash instrument, i.e., a loan.
So, the following arrangement of an end-user issuing fixed debt, receiving fixed/pay compounded SOFR and simultaneously receiving compounded SOFR/pay Term SOFR in a basis swap would not, in all likelihood, be allowed or, at the very least not be encouraged.
So, we appear to be left in a difficult situation where the end users may be forced to manage Term SOFR and compounded SOFR where previously they were only exposed to LIBOR.
Other ways forward for end-users
Many clients do not wish to manage the Term SOFR/compounded SOFR risk which they would acquire as part of a loan and fixed rate debt liability combination.
However, all is not lost. This could be managed with an active approach to the coupon dates of the debt and the calculation dates of the derivative.
Approach 1 – manage compounded SOFR to Term SOFR for a fixed debt issue:
Trade with the dealer as receive fixed/pay compounded SOFR (permitted) with terms and dates matching the debt issue.
Each rollover (coupon date), pay the USD OIS (1, 3 or 6-month as appropriate) to swap the compounded SOFR to a fixed rate to replicate Term SOFR.
While this approach achieves the desired outcome of fixing the SOFR rate for 1, 3 or 6-months, there are some challenges:
The operational risk of diarising and executing the USD OIS trades needs to be closely managed.
Term SOFR is calculated from rates across the CME trading day (see note below) and there may be slippage between Term SOFR, and the USD OIS rate traded on the day.
It is important to carefully match the settlement dates for each leg to ensure there is minimal impact on the cash management which could attract significant costs.
This approach is actually quite effective and could be a practical alternative to Term SOFR under circumstances where Term SOFR cannot be referenced.
Approach 2 – choose a point in time for your firm to fix the rate
In this approach, the firm decides on a specific time to transact the USD OIS and accepts there will likely be a difference from Term SOFR.
This is operationally much easier but can provide tracking errors if other components of the portfolio are referencing Term SOFR.
Term SOFR calculations and timing
Term SOFR is calculated in a very different way to the current USD LIBOR.
USD LIBOR is determined at a point in time, specifically 11 am London. If a firm were trying to replicate LIBOR, then trading at 11 am London in a market closely connected to LIBOR (e.g., a single period swap) would likely have little slippage.
However, Term SOFR is not calculated at a point in time.
Term SOFR is calculated as follows (CME description):
‘A set of Volume Weighted Average Prices (VWAP) are calculated using transaction prices observed during several observation intervals throughout the trading day. These are then used in a projection model to determine CME Term SOFR Reference Rates. Full details of the calculation methodology are available on the Term SOFR webpages.’
If you wish to replicate Term SOFR, you will need to trade a proportion of the USD OIS risk at each time CME accesses the price for the VWAP. This is made even more difficult because CME uses random times in each time bucket!
In practice, CME uses fourteen , 30-minute intervals with random time sampling which is not possible to exactly replicate without knowing the timing of each sample.
In practice, this makes it difficult to manage a USD OIS process to replace Term SOFR
USD OIS trades to replicate Term SOFR
Our analysis of USD OIS and Term SOFR since May 2019 (when Term SOFR was first published) gives some comfort that a practical approach could be found.
Example 1 - Trade half the USD OIS risk CME near market open and the other half near the close.
Average slippage is 1 basis point (bp).
Standard deviation is 4 bps.
Maximum is 26 bps.
Minimum is -22 bps.
The average and standard deviation are quite acceptable to many firms, but the outliers (maximum and minimum) are less attractive outcomes as the slippage is substantial.
The average slippage is within 2 standard deviations for 99.9% of time which may provide some comfort.
Example 2 – Performance over a 3-year quarterly swap traded each day.
Over the twelve rate fixes in a 3-year quarterly swap, the statistics are:
Average slippage is 2 bps.
Standard deviation is 1 bps.
Maximum is 4 bps.
Minimum is -1 bp.
The averaging process appears to be quite effective, with the maximum and minimum much reduced.
Over a 3-year swap, there may be some significant slippage days but, on average, the total outcome may be acceptable.
Summary
The recent ARRC announcements include recommendations which may allow end-users to hedge a wider group of Term SOFR exposures. But CME licensing still appears to restrict the use of Term SOFR to cash instruments and derivatives directly linked to those cash instruments.
Should the CME position change, firms could reconsider the Term SOFR use case.
In the meantime, there are practical and effective ways to replicate Term SOFR, some of which are described above.
But there are some risks and caveats:
Term SOFR is difficult to match exactly using USD OIS trades because of the timing and random nature of the Term SOFR calculation.
There can be slippage between USD OIS and Term SOFR which may cause tracking issues if parts of the portfolio reference Term SOFR.
There are operational aspects of trading USD OIS which need to be closely managed including date and settlement timing.
On the positive side:
The slippage appears to average out over time and across the rolls for a multi-roll swap.
A process could be put in place to manage the USD OIS trading and achieve quite acceptable rate fix and operational exposure.
In summary, if you need Term SOFR but are not able to access it for licensing reasons, there are alternatives.
How can Martialis assist?
Martialis can assist in this process by:
Designing appropriate operational procedures to manage the USD OIS trading and risk management;
Providing practical advice on establishing trading relationships;
Transacting and recording the USD OIS trades to ensure date and settlement matching;
Calculating any slippage to Term SOFR; and
Monitoring risks and pricing requirements.
While replicating Term SOFR appears to be complex, our experience shows this can be managed effectively and methodically if processes are robust and established proactively.