After increasing markedly over the weekend from 2.2% to 2.43%, on Tuesday night the Secured Overnight Financing Rate exploded to 5.25% indicating major issues in interbank lending confidence.
Following concerns over LIBOR stability, the Federal Reserve and New York Fed in 2014 had established an Alternative Reference Rates Committee, which launched SOFR as a transaction, rather than judgement based overnight reference rate. According to the New York Fed, as of September 2019 there was a daily notional volume of around $1 trillion in transactions in the SOFR rate.
In 2017, the UK Financial Conduct Authority announced that LIBOR was to be phased out by the end of 2021, hastening efforts by the financial services markets and authorities globally to devise secure, ‘risk-free’ alternative overnight reference rates.
As a transaction-based rate the SOFR rate was widely regarded as both more stable and more likely to closely mirror the Fed’s Effective Funds Rate. However, in doing so, it would also be a poorer gauge of underlying fundamentals in the credit market than the LIBOR rate. SOFR OIS or futures are paid out with a compound average of the three-month term of the instrument.
Data from St Louis Fed shows that while SOFR largely mirrored the Fed’s Effective Funds Rate, there had been warning spikes leading up to Monday’s jump. The two-session jump from 2.2% to 5.25% is absolutely unprecedented, and perhaps is acting as a canary in the coal mine for some major credit market disruption.
It also suggests that the modelling of SOFR developers was badly mistaken in failing to take into account market reaction effect. The ‘historical’ SOFR rate was clearly a blind rate that failed to take into account the internal feedback loop created by having SOFR data.
In any case, SOFR is now working not as expected at exactly the point that it should have been moving to take LIBOR’s place as the global standard interback overnight reference rate.
What if LIBOR were to collapse prior to 2021?
There are also major risks associated with LIBOR stopping prior to being phased out. With $200 trillion in derivatives still referencing LIBOR, there is the potential for a major loss of confidence in derivative contracts were LIBOR to be withdrawn prior to its planned phase out.
Dr David Bowman of the Federal Reserve in a lecture last year to the University of Chicago, describes this scenario as follows:
If LIBOR did stop, say today, a bunch of really terrible things would happen based on the contract language that people have. I think the US and global financial stability would be seriously threatened by that bad contract language. So, that’s where the main financial stability concern is. […] What makes it difficult is how intertwined LIBOR is in a host of legacy trades, and that will be very, very difficult to unwind.
You can watch the full presentation below:
Board of Governors of the Federal Reserve System (US), Effective Federal Funds Rate [DFF], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DFF, September 18, 2019.
Federal Reserve Bank of New York, Secured Overnight Financing Rate [SOFR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/SOFR, September 18, 2019.
ICE Benchmark Administration Limited (IBA), 3-Month London Interbank Offered Rate (LIBOR), based on U.S. Dollar [USD3MTD156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/USD3MTD156N, September 18, 2019.