Advocates for the adoption of SOFR as a replacement rate for LIBOR said at the ABS East securitization conference in Miami on Monday that recent disruptions to Treasury repo markets were not necessarily of significant importance to credit investors. But sources on the sideline of the conference voiced some concerns about how further spikes in SOFR volatility are all but guaranteed in coming years.
SOFR and the repo spike
SOFR is a secured overnight financing rate, referencing the rate paid by borrowers in overnight repo transactions collateralized by U.S. Treasuries. It was chosen as a replacement for USD LIBOR, which is expected to no longer be requested from the U.K.’s Financial Conduct Authority to panel banks after 2021.
Some repo rates spiked to almost 10% last week as financial institutions active in the repo market had a great demand for cash and an oversupply of Treasuries to collateralize repo transactions, in a market that some describe as the “core of the core of the financial system.”
Sources say last week’s cash drain was driven by three factors in roughly equal parts: corporate tax payments due to the U.S. government, the Saudi Arabian government drawing around $80 billion from the repo market, and supply-driven technicals in Treasury bond issuance.
The Fed has since bought billions worth of Treasuries through open market operations to bring the market into better balance and stabilize secured overnight rates closer to its targeted fed funds rate.
Still, the fact that the United States’ chosen replacement rate for “the world’s most important number” can carry such volatility has a number of market participants on edge.
In particular, SOFR’s acceptance relies on the New York Federal Reserve—which runs market operations on behalf of the Federal Reserve system through its open market trading desk—and its ability to step in and stabilize repo markets on a near-continuous basis.
While Treasury repo markets have predominantly been stable since the financial crisis, the drain of excess bank reserves since the end of QE could result in more frequent cash shortages in the repo market, sources say.
Not all have a great deal of confidence in the New York Fed’s ability to effectively manage volatility.
“There have been a number of public personnel changes at the New York Fed, and it’s clear that they were caught off guard when this problem erupted early last week,” one source said.
The source opined that the markets team waited too long to finish conducting its first repo operation until Tuesday morning at 10:10 a.m., by which time the market was already in “free-fall.”
“The line from the desk should have been ‘whatever it takes’ from early, early Tuesday morning,” the source said.
Still, those advocating for SOFR point out that the potential market volatility will not affect the net margin that most investors would receive from a SOFR-linked asset, given that the rate is predominantly determined by a smoothed average of the rate over an extended period of time.
“An average of SOFR, which is the rate that is actually used in the marketplace, remains very stable,” wrote Tom Wipf, managing director at Morgan Stanley and current chair of the Alternative Reference Rates Committee (ARRC), in a letter to ARRC members on Sept. 19.
“Even with the recent movements in rates and today’s prints, we calculate that a 3-month compound average of SOFR only rose two basis points compared to rates last week. By contrast, three month LIBOR rose four basis points relative to rates last week,” Wipf wrote.
Furthermore, Peter Phelan, deputy assistant secretary for capital markets at the U.S. Department of the Treasury, said on Monday morning that there was little that the U.S. government could do to halt the end of LIBOR.
“We don’t have an ability to do much with LIBOR, and the U.K.’s FCA said it will not compel banks to submit LIBOR after 2021. We just think it’s important for people to recognize that we don’t have control,” he said.
New York Fed President John Williams was even more direct today, at the bank's 2019 U.S. Treasury Market Conference, where he noted a concerning population of market participants wearing "rose-tinted glasses" and "getting nostalgic about LIBOR and hoping for an extension to the deadline or a reincarnation of the rate."
"I cannot emphasize enough that the clock is ticking and everyone needs to get their firms ready for January 1, 2022," Williams said, highlighting the $200 trillion of financial contracts referencing USD LIBOR.
Still, a growing number of market participants are sharing doubts about the ability and competence of central bankers to do ‘whatever it takes’ and support crucial funding markets in the medium term.
“Last week’s episode is a signal of how quickly a liquidity issue can arise in the financial system, but it also is yet another dent in the credibility of central banking,” said Mohamed El-Erian, chief economic advisor at Allianz Global Investors, in a keynote address at the ABS conference.
“The initial response was not sufficient. It took time for the solution…to take hold. That is yet another dent in the reputation of central banking and a further sign that we are leaving the golden age of central banking behind.”
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