August 26, 2020 - You can’t judge a book by its cover, the saying goes. Apparently you can’t judge an article by its headline either. A recent news headline suggested that SOFR conventions for the upcoming LIBOR transition are “splintering” and that this could “sow confusion and hedging uncertainty”. In fact, the commentary in the accompanying article was more nuanced and not particularly alarmist – indeed, nearly every quote observed that any risks were very manageable – but by only reading the headline or doing a quick skim, readers could assume the opposite. And so, we wanted to reflag the key issues and takeaways from said article.

First up was a concern around “basis risk”. Basis risk is the risk that two related contracts using two different interest rates will behave differently, leading to economic gains or losses. Thus, ideally, if you are hedging a loan, your derivative hedge will use exactly the same rate. But here’s the issue: There’s little basis risk in SOFR. As this LSTA Basis Risk Update and the article itself noted, the basis between Simple and Compounded SOFR has been around one basis point or less since 2008, and even when rates were higher, it was generally only a few bps. Ergo, not much basis risk. And, in fact, the risk that exists can be managed. This was reflected in the associated quotes:

• “It’s a legitimate and real concern,” says David Knutson, head of credit research at Schroders. “Hedging inefficiencies are just air pockets, so they can create problems, but if a good pilot understands them and can anticipate them, then they can be managed.”

• Sairah Burki, managing director of regulatory policy at the Commercial Real Estate Finance Council, is also confident basis risks can be managed. “For lenders, there’s going to be a basis issue somewhere,” she says, adding: “I think the market will resolve it with some kind of hedging structure.”

Moreover, even though basis risk is low, if a borrower or lender wanted to avoid all basis risk, that’s feasible too.

• Ann Battle, assistant general counsel at the International Swaps and Derivatives Association, says dealers will adapt and offer bespoke swaps to cope with any basis issues that arise. “The OTC derivatives market developed to enable hedging on a bespoke basis. So, I expect we’ll see people come up with different strategies,” she says.

It is likely due to the realization that the basis risk is not that problematic that markets began to develop solutions that fit them best. Indeed, speaking as the co-chair of the ARRC’s Business Loans Working Group (BLWG), this is exactly what transpired in the syndicated loans space.  Once we became familiar with the characteristics of SOFR – its operability and economics – we determined that Daily Simple SOFR may be better “fit for purpose” than Compounded SOFR for business loans. Why?  In the loan market, because we have prepayments and loans trade without accrued interest, SOFR “Compounded in Arrears” introduces many complexities and significant operational risk. Daily Simple SOFR is much easier to implement, is analogous to Daily LIBOR or Daily Prime (which is used today) and economically is nearly identical to Compounded SOFR. Once we learned that, it was quite rational to replace Compounded SOFR with Daily Simple SOFR in the ARRC’s Hardwired LIBOR Fallbacks. (Though, being reasonable people, we kept a Compounded SOFR option for hedging purists.)

Other markets appear to have made similar determinations on what’s “fit for purpose” for them. The mortgage market is using “SOFR Compounded in Advance”, which is calculated by looking back to the previous period, determining the compounded rate and then locking that rate in at the beginning of the period. This reflects the need to inform consumers of their interest rate 45 days in advance – a need that SOFR Compounded in Advance resolved.

• “A consumer mortgage cannot be treated as a utility bill where you find out at the end of the month what the interest payment you owed was,” says Ameez Nanjee, vice-president for asset and liability management in the investments and capital markets division at Freddie Mac.

And, again, the basis issue might not be that material for the mortgage market; the cash flows for the mortgages and any hedges generally will be matched, just offset for a period of time.

• “The only difference will be the timing of those cashflows,” says Nanjee at Freddie Mac. “The cashflows themselves will be the same. So, yes, the in-advance rate will lag in that situation, so ultimately it comes down to the discounting cost of one month of a lag payment.”

Thus, the article demonstrated that there were basis issues that ARRC participants analyzed carefully – and ultimately came to the conclusion a small amount of basis was i) manageable and ii) less important than developing a solution that worked for a particular market.

At the end of the day, the headline – “Rival SOFR conventions splinter loan market” – was eye catching. But the article itself offered a more nuanced interpretation.