It’s just 65 days until the final five US dollar LIBOR settings cease to exist or become non-representative. At that point, trillions of dollars of LIBOR-linked loans and other cash instruments will switch to fallbacks referencing term SOFR, potentially adding to demand for term SOFR hedges. This could push dealers closer to internal limits on the amount of term SOFR risk they can take on, eventually restricting their ability to offer term SOFR derivatives to end users. In response, the Alternative Reference Rates Committee (ARRC) has refined its term SOFR scope of use recommendations, introducing another avenue for dealers to lay off their risk, while continuing to recommend that overall use of term SOFR remains limited.
The ARRC has always been clear that term SOFR plays an important role in the transition from US dollar LIBOR for the loan market, but has emphasized that use of term SOFR should be minimal to ensure this rate remains robust in future. While SOFR itself is based on US dollar repo transactions, term SOFR is a separate rate based on derivatives referencing SOFR and therefore depends on a deep and robust SOFR derivatives market. Fewer people using SOFR-linked derivatives could therefore undermine the viability of term SOFR.
When it comes to term SOFR derivatives, the ARRC previously recommended these instruments should only be used by end users hedging cash products that reference term SOFR and specifically stated that term SOFR should not be used in the interdealer market.
The policy of concentrating liquidity in overnight SOFR derivatives has worked so far: 61.5% of cleared over-the-counter (OTC) and exchange-traded US dollar interest rate derivatives DV01 referenced SOFR in March, up from 41.1% a year ago, according to the ISDA-Clarus RFR Adoption Indicator. Based on data from the Depository Trust and Clearing Corporation’s swap data repository, term SOFR transactions accounted for less than 3% of monthly SOFR-linked OTC interest rate derivatives traded notional in 2022.
When it comes to legacy contracts, central counterparty conversions of cleared US dollar LIBOR derivatives are accelerating the market’s transition to SOFR-linked derivatives. In addition, fallbacks for US dollar LIBOR in ISDA’s standard definitions, as well as the ISDA 2020 IBOR Fallbacks Protocol and the LIBOR Act, will result in non-cleared derivatives referencing a SOFR-based fallback rate.
Nonetheless, term SOFR can be used as a reference rate for new business loans and certain securitizations and as a fallback for many legacy LIBOR cash products, which means there has been and will likely continue to be demand for term SOFR hedges. Dealers have so far warehoused this predominantly one-way risk exposure, raising concerns that they may eventually hit risk limits, pushing the cost of term SOFR hedges to prohibitively high levels.
The ARRC’s update to its best practice recommendations is intended to give dealers an additional means of offsetting the risk accumulated by offering term SOFR hedges to end users. Specifically, the ARRC now recognizes the ability of dealers to enter into term SOFR-SOFR basis swaps with any non-dealer participant including hedge funds and asset managers, even if the non-dealer firm does not have a term SOFR cash exposure.
In the update, the ARRC emphasized the purpose of the change is not intended to lower the cost of term SOFR hedges so they are in line with overnight SOFR, but to help ensure that term SOFR liquidity remains available to those end users that need it. It reiterated its opposition to interdealer trading of term SOFR derivatives, including term SOFR-SOFR basis swaps.
As we approach the deadline for LIBOR’s demise, it’s important that no stone is left unturned to ensure the market has everything it needs to manage a successful transition. We urge firms that haven’t yet finalized their arrangements for the switch to make full use of the remaining 65 days. To help, ISDA will continue to provide research, educational resources and transition tools (such as the ISDA 2020 IBOR Fallbacks Protocol) as we approach June 30.
Final preparations for LIBOR transition will be one of the topics at this year’s ISDA Annual General Meeting – book your delegate pass here.
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