Why SOFR Makes a Big Trader Uneasy
As LIBOR winds down, one derivatives trader worries its replacement will do a poor job hedging risks in turbulent times: “For somebody who wants to hedge their borrowing costs, [SOFR] leaves a lot to be desired.”
Dollar LIBOR’s fate is set: It will no longer be available for new loans and other products starting on Jan. 1, mostly replaced by the benchmark that regulators want. But that doesn’t mean everybody loves the Secured Overnight Financing Rate (SOFR), the leading U.S. alternative.
Take Don Wilson, founder of Chicago-based trading firm DRW, which will play a big role in the Libor-to-SOFR transition since his company trades derivatives tied to both rates. He thinks regulators made a mistake promoting SOFR as the right solution for everyone.
The problem, according to Wilson, is that SOFR will do a poor job hedging risks in turbulent times. “For somebody who wants to hedge their borrowing costs, it leaves a lot to be desired,” the 53-year-old said in a recent Zoom interview from Miami, after his sailing team Convexity had just won a world championship there. “It’s a great product as long as credit spreads remain static. The time it really falls apart is in a crisis.”
The early days of the pandemic help illustrate that. When Covid fear ripped through markets in 2020, three-month LIBOR spiked as lending markets locked up. But the comparable SOFR fell, dragged lower by the Federal Reserve slashing interest rates. In other words, SOFR didn’t reflect just how challenging credit markets were.
Wilson’s critique isn’t new—and he’s not alone. But he’s a prominent voice on the subject as LIBOR winds down. DRW is one of the biggest Chicago-based trading firms. It’s a major market maker in euro-dollar derivatives, which are tied to LIBOR, and it also trades SOFR contracts. DRW—which also has cryptocurrency, venture capital, and real estate divisions—employs more than 1,200 people and, according to people familiar with the matter who spoke earlier this year, generated about $750 million in earnings before interest, taxes, depreciation, and amortization (EBITDA) in 2020. Wilson started his career in the Chicago Mercantile Exchange’s euro-dollar trading pits before founding DRW in 1992.
SOFR has been dogged with complaints since the Fed-backed Alternative Reference Rates Committee (ARRC) anointed it as the new benchmark for key dollar markets more than four years ago.
U.S. officials continue to stand behind their choice. “SOFR is a robust rate built on a durable base of overnight transactions,” Nathaniel Wuerffel, a senior vice president in New York Fed’s markets group, said in an Oct. 27 speech.
SOFR is calculated using transactions on overnight repurchase agreements, or loans collateralized by U.S. Treasuries. (The median daily volume underlying SOFR was $1 trillion in 2020, according to Wuerffel.) As a result, it tends to follow whatever the Fed is doing with interest rates, ignoring — to some extent — whatever stresses there might be in credit markets. When the Fed cuts rates, as it often does during a crisis, that should pull SOFR down.
But that means it won’t really work for someone trying to hedge credit risks. LIBOR tends to jump during a crisis, meaning it’s useful for that purpose.
“When there is stress on the financial system, that’s when it’s really going to fall short,” Wilson said. “Which, of course, if we’re concerned about the resilience of the system, we need to make sure that your hedging products especially work during that period. Because that’s when they’re most critical.”
Regulators, he said, have “decided they want everyone to use SOFR. I cannot explain it.”
The Bloomberg Short Term Bank Yield Index, known as BSBY, is administered by Bloomberg Index Services Ltd., a subsidiary of Bloomberg LP, the parent of Bloomberg News. It competes with other benchmarks such as SOFR, ICE Benchmark Administration’s Bank Yield Index, and American Financial Exchange’s AMERIBOR.
“We have seen recent innovation in reference rates, including those with credit-sensitive properties,” the New York Fed’s Wuerffel said in the October speech. “It is understandable that credit-sensitive rates could be conceptually appealing for certain use cases, but it appears that at least some of the attraction is that credit-sensitive rates behave very similarly to LIBOR,” he added. “Choosing reference rates only because of their similarity to LIBOR could very well end poorly.”
—With assistance from Caleb Mutua.
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