A Commodity Futures Trading Commission (CFTC) subcommittee recommended as a “market best practice” that interdealer brokers switch trading of linear interest rate swaps from the London Interbank Offered Rate (LIBOR) to the Secured Overnight Financing Rate (SOFR) beginning July 26.
The recommendation by the CFTC’s Interest Rate Benchmark Reform Subcommittee is aimed at speeding the adoption of SOFR, which has yet to gain widespread acceptance as a replacement for LIBOR, the reference rate for trillions of dollars in business loans, derivatives and other financial contracts worldwide. U.S. regulators have called on banks to stop using LIBOR in new contracts by the end of this year.
The subcommittee’s “SOFR First” Transaction Initiative only focuses on the interdealer market and will not influence availability of LIBOR linear swaps in dealer-to-client transactions, the CFTC said.
Many corporate treasurers and financial institutions have not adopted SOFR as a reference rate because it lacks some of LIBOR’s useful traits.
SOFR is based on overnight repurchase agreements secured by Treasuries and, unlike LIBOR, does not reflect credit risk or expedite the creation of a term structure enabling treasurers to make forward-looking rate calculations.
LIBOR is based on London banks' estimates of what they would be charged when borrowing from other banks. The LIBOR rate can be forecast three, six and 12 months into the future.
The U.K. Financial Conduct Authority, the administrator for LIBOR, announced in March that it will delay to mid-2023 the sunsetting of some of the most commonly used tenors of the benchmark rate.
The final fixings for most LIBOR rates — including one-week and two-month U.S. dollar LIBOR — will be made on Dec. 31, 2021, but other U.S. dollar tenors may continue until June 30, 2023.
A lack of liquidity in derivatives linked to SOFR has discouraged companies from writing contracts in the new reference rate and inhibited creation of SOFR term rates. The “SOFR First” Transaction Initiative will help solve that problem, Federal Reserve Vice Chair Randal Quarles said in a statement.
The CFTC subcommittee’s recommendation “will increase the volume of transactions quoted in SOFR, and thus fulfill the final market indicator for the implementation of a term rate for SOFR,” Quarles said.
“As a result, term SOFR will be available upon implementation of the change in quoting conventions, removing the last obstacle to using SOFR as a replacement reference rate,” he said. “There is now no excuse to delay transition as the path that leads beyond LIBOR could not be clearer.”
Despite warnings from regulators since 2017, many companies in recent years have failed to switch to new reference rates, Quarles said in March, noting that use of U.S. dollar LIBOR has increased to nearly $223 trillion in outstanding financial contracts from about $200 trillion in 2018.
The “SOFR First” Transaction Initiative “is an important step to increase overall SOFR swap volumes and facilitate a smooth transition of liquidity towards SOFR,” Acting CFTC Chair Rostin Behnam said in a statement.
After July 26, interdealer broker screens for U.S. dollar LIBOR linear swaps should only serve an informational purpose and should be shut off after Oct. 22, the CFTC’s subcommittee said.