What is happening to SOFR?
A lot of scandals during the financial crisis, including market manipulation, caused the market to lose confidence in IBOR. This applies specially to LIBOR and EURIBOR. Therefore, it was recommended to reform the current reference rates and find close to risk-free rates. January 1st 2022, LIBOR was terminated and SOFR was established as the new standard for USD.
Secured Overnight Financing Rate (SOFR)
SOFR replaced USD Libor on January 1st, 2022. USD Libor will continue to be used as a reference rate for some counterparties and maturities until end of June 2023.
SOFR have 1-day maturity, and it has no credit- or liquidity premiums, unlike IBOR. This means that the margin against SOFR is higher than on similar loans and hedges against IBOR.
All floating rate loans and interest swaps were supposed to use SOFR as a reference rate in 2022.
Challenges with SOFR
Using real trades, makes SOFR much less stable than LIBOR. Such volatility could add uncertainty or extra risk on common trades.
SOFR is only an overnight rate, while LIBOR came in many different maturities.
Financial products which use SOFR as a reference rate is a backward-looking rate. As it is a backward-looking rate, the rate is unknown in advance of the interest period. You simply don’t know the interest amount to pay in advance.
The adaptation to new SOFR based products.
Something happened in 2022. Simple SOFR was replaced with the following reference rates on many funding products:
- Daily Compounded SOFR
- Average SOFR
- TERM SOFR
Daily Compounded SOFR also uses the overnight SOFR rate, which is then compounded daily during the interest period to determine the loan's interest rate. That means that the interest accrues. You will still need daily SOFR rates to calculate it, but you will also need the compounded calculation. This is also backward-looking so the amount of interest owed by the borrower would not be known until the end of the period.
Many counterparties also introduced Average SOFR in 2022 on funding products to decrease volatility. The most common ones are 1-Month Average SOFR, 3-Month Average SOFR and 6-Month Average SOFR. Instead of daily interest fixes (SOFR), the interest is set at the end of the period based on the Average SOFR. A 3-month Average is less volatile than a 1-month average, but the extra 2 months are less relevant to today’s rates. With longer smoothing periods, it is no longer representative of market conditions. This is also backward-looking.
CME Term SOFR was introduced on most funding products and derivatives. CME Term SOFR is a daily set of forward-looking interest rate estimated, calculated, and published for 1-month, 3-months, 6-months and 12-months. It is published on daily basis by CME Group.
Why borrowers prefer TERM SOFR?
Borrowers may use TERM SOFR instead of SOFR because it provides greater predictability and stability for them.
SOFR can be volatile and subject to significant fluctuations from day to day, which make it difficult for borrowers to plan and manage their borrowing costs over time. In contrast TERM SOFR can be used to set interest rates for loans with longer durations than overnight. It is forward-looking like the LIBOR.
This means that TERM SOFR can provide borrowers with greater predictability and stability in their funding costs, as it is less susceptible to daily fluctuations in interest rates.
Additionally, some borrowers may prefer TERM SOFR because it may be easier to explain and understand, as it is a single rate.
Overall, borrowers may choose to use TERM SOFR instead of SOFR to manage borrowing costs and risk, to provide greater predictability and stability.
Make sure your internal IT systems handle the transition from USD Libor to SOFR and CME Term SOFR. Do your systems handle daily interest fixing? Do the systems include daily SOFR and CME Term SOFR-rates? Do your systems handle compounded interest calculations?
Albert H. Vedeler, has worked with Treasury related issues for 23 years in Stacc Escali. Stacc Escali is a leading supplier of Treasury Management Systems and Portfolio Management Solutions in the Nordics. He has worked with many clients which has converted funding products based on USD Libor to Simple SOFR, Compounded SOFR, Average SOFR and CME TERM SOFR.