Jefferies LLC economists have called the transition away from the scandal-plagued London Interbank Offered Rate “the most important development in the financial markets in the years immediately ahead.” And there are developments aplenty.
Without much fanfare, the World Bank this week issued $1 billion of two-year floating-rate notes tied to the U.S. Secured Overnight Financing Rate, or SOFR. It’s the second sale of such debt after a $6 billion offering from Fannie Mae on July 26 with tenors of six months, 12 months and 18 months. Suddenly, the Libor alternative is picking up some momentum, with Bloomberg News’ Maciej Onoszko reporting that Toronto-Dominion Bank now expects a company or financial institution to tap the market in a matter of months.
There’s still a long way to go — more than $150 trillion of securities are benchmarked to U.S. Libor, so these two deals are a comparative drop in the bucket. But given that the rate was just introduced in April, and just two weeks later the Federal Reserve Bank of New York disclosed it had made errors with its settings, the deals can be viewed as a vote of confidence. At the very least, it makes the idea of abandoning Libor by the end of 2021 a little less scary.
For those not typically in the weeds of short-term interest rates, Libor is based on a daily poll of banks, asking them to estimate how much it would cost to borrow from one another without collateral. This made it ripe for manipulation, and, indeed, it was revealed that dozens of firms, including large U.S. and European banks, had colluded to set the benchmark at levels that would benefit them.
In a search for something that wouldn’t be manipulated (or, at least, would be vastly tougher to rig), the Alternative Reference Rates Committee, made up of Wall Street banks and regulators, settled on a rate that’s calculated based on overnight loans collateralized by U.S. government debt. It focuses on data from actual transactions, taking out the guesswork that allowed banks to game Libor.
SOFR-linked futures are now up and running, too. As for the World Bank’s $1 billion deal, 27 investors placed orders for $1.4 billion, according to a statement. Central banks and official institutions made up more than half the buyers; pensions, insurers and asset managers took 23 percent; and bank treasuries and corporations took about 22 percent.
Randal Quarles, the Fed’s vice chairman for supervision, seems pleased with the progress. “The World Bank’s decision to issue a SOFR note sends an important signal to market participants,” he said in the statement. “SOFR is fast developing into a robust and durable reference rate that is a strong choice for a wide range of cash products.”
To reiterate: These reference rates are not easy to develop, with trillions of dollars on the line. Just look at what’s happening in Europe. Two key euro-zone interest-rate benchmarks, Euribor and Eonia, were both deemed noncompliant with EU regulations. After January 1, 2020, only compliant benchmarks are supposed to be used in new interest-rate contracts. The relevant European entities are hoping to create usable benchmarks by the fourth quarter of 2019, giving the market just three months to get everything in order. That will be a challenge.
America’s Libor alternative, on the other hand, is getting stronger by the day. As Onoszko pointed out, the World Bank and Fannie Mae are among the most sophisticated debt issuers and typically pave the way for others. The World Bank offered the first green bond, for instance. Companies don’t have the urgency to ween themselves off of Libor quite yet, but the wheels are at least in motion.
It’s neither perfect nor robust, but SOFR is starting to look more and more like the answer to what’s been called the single-most important question facing fixed-income markets today.