Beware SOFR

As the Federal Reserve prepares for its next regular meeting on Oct. 29, the uncertain state of U.S.-Chinese trade negotiations and a running debate over whether or not the U.S. economy has reached the end of its growth cycle dominate speculation. But within the banking industry that the Fed regulates, there’s a strong desire to hear more detail about the causes of a sudden spike in the so-called repo rate, a key metric that doubled on Sept. 17, forcing the Fed to resume buying up U.S. Treasury bonds—for the first time since it began winding down its huge post-financial crisis balance sheet.

The repo rate, which has hovered between 1.5 and 2.5 percent for much of this decade, governs the interest rate that banks and money market funds pay when borrowing from each other for short-term loans, often only for a single day. The loans are used to execute orders for government bonds or other assets, allowing financial institutions to make a market for a particular product and then get repaid quickly.

Volatility in the repo rate can cause a serious credit crunch in the bond market and declines in yields. But of even greater concern is the fact that the Fed has announced its intention to give the repo rate even greater influence on the global economy under a new name: the Secured Overnight Financing Rate (SOFR).

Readers of Foreign Policy may be excused for confusing SOFR with NATO’s post-Dayton stabilization mission in Bosnia back in 1996 (SFOR), but in today’s vernacular, SOFR is actually a financial instrument, and late in 2017, the Fed announced it will replace the London Interbank Offered Rate (LIBOR), which had become tainted by scandal during the financial crisis.

With the new rate not due to take full effect for two years, it may seem like the world’s quantitative analysts and banking regulators have plenty of time to get it right. But many of them are worried that SOFR’s new algorithmic approach will be harder than LIBOR to calculate and control in rocky times, which is something of an irony, because LIBOR is being replaced precisely because it was so susceptible to human manipulation.

Michael Held, the executive vice president and chief counsel of the New York Federal Reserve Bank, is one of the fearful. He recently said that the switch to SOFR keeps him up at night. While he said he’s optimistic (as he must be publicly given his post) that the Fed will pull it off seamlessly, nonetheless he’s not alone in worrying.

The concern makes sense: A key component of the global financial system—a rate that affects $200 trillion in U.S. financial contracts and another $170 trillion globally, a system that governs the rates on retirement funds, student loans, mortgages, and auto financing—is being scrapped for an untested alternative. What could go wrong?

Following the 2007-2008 global financial crisis—known as the GFC in the acronym-crazed claret bars of the City of London—a number of the global financial institutions that make up the 17-member LIBOR rate-setting board were found to be juicing the numbers. The manipulations took two forms. During the run-up to the crisis, some banks apparently colluded to set higher rates with obvious benefits to their balance sheet. And then, on the eve of the crisis, the manipulation reversed itself. Concerned that high rates would appear to confirm fears of financial trouble, the rate setters fixed rates lower, which hid the dire straits that many of systemically important banks found themselves in. As punishment, Deutsche Bank, Barclays, UBS, Rabobank, and the Royal Bank of Scotland ultimately paid over $9 billion in fines, and about a dozen of their traders served jail time.

Ever since these practices were revealed in 2012, central banks and regulators have been working on ways to displace LIBOR. The Fed, which by virtue of the dollar’s status as global reserve currency can pretty much dictate next steps, set up the Alternative Reference Rates Committee (ARRC) in 2014, which, after four years of study, announced SOFR as its preferred alternative in 2017.

But switching rates is not as simple as it might seem. Besides the crucial role the rate plays in steadying global finance in periods of turmoil, it also governs the terms of trillions of dollars’ worth of loans globally, with LIBOR referred to by name in most of these contracts. A sudden, uncoordinated dumping of LIBOR, then, could precipitate a financial disaster, what the New York Fed’s Held warned would be “a DEFCON 1 litigation event if ever I’ve seen one.” Global credit markets could freeze up, some have surmised, as they did in the wake of Lehman Brothers’ collapse in 2008.

Particularly worrying is that LIBOR is the standard interest rate for loans that “float”—usually short-term contracts that last no more than three months before the rate resets. This is the liquidity that keeps corporate America and enterprises around the world solvent, allowing them to bridge payments to creditors and suppliers while their own staff collects from customers. Trillions of dollars of interest rate derivatives—swaps, “swaptions,” and other exotic transactions—are pegged to it. At least until late 2021, that is.

In preparation for the change, the New York Federal Reserve Bank has been quoting the new rate since April, and the number of deals pegged to it are growing. The Fed hopes that by the time 2021 comes to an end, LIBOR will simply be overtaken. So, good riddance to LIBOR? Not so fast.

Since the Treasury started tracking SOFR, on several occasions it has gyrated somewhat wildly in turbulent market moments while the staid, Savile Row-tailored LIBOR stood its ground. This has spooked some financial analysts, who fear that an interbank lending rate that is unchained from the moderating (if self-interested) influence of human bankers could wreak havoc.

There are other technical problems that the Fed and its overseas cohorts are working to solve, too. For instance, because of its novelty, SOFR has no “term” versions; in effect, the overnight rate is the only rate, so you can’t lock in a three-month rate yet. That makes it particularly unattractive to bond issuers and, frankly, anyone who remembers what an adjustable-rate mortgage is. LIBOR, by contrast, comes in seven different maturities—overnight, one week, one month, two months, three months, six months, and 12 months. This allowed banks some flexibility in finding the best terms for their transactions. As long a SOFR lacks such “term” offerings, it’s easy for bankers to paint dark scenarios of what a fluctuating daily rate would have done to their balance sheet on a longer-term loan.

With so many outstanding contracts pegged to a floating rate that is now doomed to expire in a couple of years, financiers fear that securities lawyers are poised to strike.

And then there are the lawyers. With so many outstanding contracts pegged to a floating rate that is now doomed to expire in a couple of years, financiers fear that securities lawyers, a particularly litigious lot on this side of the Atlantic, are poised to strike. They’re a bit like Iraqi insurgents after former U.S. President Barack Obama set a date for the withdrawal of U.S. troops from Iraq: biding their time, sharpening their pencils, and forecasting a windfall of lucrative lawsuits should the new rate cost their clients a penny more than LIBOR might have.

Michael Bright, CEO of the Structured Finance Industry Group, which speaks for securities brokers, fears that many market players simply will not risk abandoning LIBOR. Writing in American Banker, he noted that moves are afoot to create a “synthetic LIBOR with SOFR as the key underlying component, to be used in legacy deals until they mature.”

This led to a new spate of abbreviations, from QE (quantitative easing) as the Fed pumped money into the damaged global economy, to, in Europe, ELA (emergency liquidity assistance), the rainy-day fund that kept the PIGS (debt-ridden Portugal, Ireland, Greece, and Spain) alive when they were yanked back from the trough.

The PIGS survived, and even if Greece’s continuing financial challenges did not lead to “Grexit,” the eurozone’s bailouts helped fuel calls for Brexit, just as the Troubled Asset Relief Program’s (TARP) infusions of billions into the hands of the same U.S. bankers who caused the problem in the first place helped birth yet another abbreviation: MAGA.

SOFR’s teething problems may well be solved before its 2021 deadline. Or perhaps the Fed’s declaration that LIBOR will be replaced will turn out to be a financial version of former U.S. President Jimmy Carter’s 1980 deadline for the complete conversion of the United States to the metric system. But it’s an issue that bears watching. Clumsy abbreviations have a way of causing trouble.