SOFR update for customer hedging programs

CME Term SOFR’s dominance and associated basis risk

As many market participants know, CME Term SOFR is the forward term version of SOFR. It has become the main SOFR index for lending used by U.S. FIs. This term rate is the most similar to LIBOR, allowing customers and institutions to know payment detail in advance.

Looking at our clients who offer customer-hedging programs, CME Term SOFR is the index of choice by a considerable margin. Below is a breakdown of the floating rate index used for customer-hedging transactions over the past 20 months.

This significant use exists despite the well-documented CME Term SOFR basis, which caused dealer pricing to widen beyond 10 basis points for some longer-term structures.

As a refresher, CME Term SOFR was a later-developed SOFR rate index the Alternative Reference Rates Committee (ARRC) endorsed after pleas from the market for a term rate version. However, it came with restrictions. The limited endorsement from ARRC prohibits the trading of CME Term SOFR swaps in the inter-dealer or broker market. Since end-users and non-dealer FIs can hedge their exposure to CME Term SOFR per regulatory guidance, the direction of trading for these dealers has predominantly been receive fixed/pay CME Term SOFR to their counterparties. This results in liquidity providers having inflated levels of exposure to CME Term SOFR with a limited ability to directly hedge this exposure.

The ARRC has been steadfast in its strong recommendation and support of the use of overnight SOFR and SOFR averages “where a party wishes to hedge in the most efficient and transparent manner”¹ and to help ensure there is financial stability in using Term SOFR which relies on “a deep and liquid SOFR derivatives market based on overnight SOFR”². Because of the lack of ability to directly lay off CME Term SOFR risk, dealers and liquidity providers must hedge using products available to them that use overnight SOFR such as USD-SOFR-OIS Compound (SOFR Compound).

Since dealers and brokers need to rely on using hedges tied to overnight SOFR and larger volume traders such as asset managers require the most efficient hedging vehicles, SOFR Compound is the most traded index in the derivatives market and thus the most efficient and cost-effective. Average SOFR or simple SOFR (daily weighted average of SOFR) is equally as efficient and most similar to SOFR Compound so it also affords cost benefits compared to CME Term SOFR.

The basis between SOFR Compound and CME Term SOFR is a tangible risk because of a potential difference in a CME Term SOFR fixing vs. the actual overnight SOFR settings and subsequent calculations in SOFR Compound. Per the ARRC, “Term SOFR rates are based on derivative products, primarily SOFR futures markets, not directly on the overnight Treasury repo market that underpins SOFR itself.”³ Therefore, CME Term SOFR is the forward projection of SOFR Compound. During times of uncertainty and misalignment in projected vs actual rates, dealers must hedge themselves and price in this risk accordingly.

As the CME Term SOFR basis climbed in 2022, the market pushed regulators and the ARRC for additional relief. On repeated ARRC Office Hours calls, it was shared that the ARRC was forming a sub-committee to investigate possible avenues of relief for the market, since ultimately the costs of the CME Term SOFR basis are passed along to end users. This past April, the ARCC announced that it would provide an additional use case for CME Term SOFR derivatives trading that would allow dealers to enter into CME Term SOFR basis swaps with any non-dealer regardless if the non-dealer has a direct CME Term SOFR cash product. This change would allow dealers an outlet to directly hedge their risk. In the release of this additional use case for CME Term SOFR, ARRC continued to restrict inter-dealer trading of CME Term SOFR and to support overnight SOFR and SOFR averages.

The result of this additional use case has assisted in reducing the basis and improving pricing execution. However, the situation remains fluid given the uncertainty of future rate movements and volume of counter-CME Term SOFR basis directional hedging. Based on the ARRC’s April announcement where it stated that it “does not intend to revisit its Best Practice Recommendations for the use of Term SOFR, which are meant to apply as permanent recommendations for the market”⁴. Chatham believes that CME Term SOFR will continue to trade at a higher cost for the foreseeable future. As a side note, we have been very successful in assisting our clients in taking advantage of the CME Term SOFR basis by executing receive fixed/pay CME Term SOFR hedges to reduce their asset-sensitive risk positions at attractive pricing levels.

Key considerations for SOFR alternatives

FIs should continue to evaluate alternatives based on potential savings, competition, and sophistication level of borrowers.

To illustrate the cost savings and differential of CME Term SOFR and SOFR Compound (or daily weighted average SOFR), below is a graph showing the estimated difference in rate (CME Term SOFR basis) by tenor as well as a table depicting potential savings over the life of a $25M amortizing swap by using an overnight SOFR or SOFR average rate:

It is this efficiency and cost savings that have driven larger and more sophisticated clients to consider alternatives to CME Term SOFR, especially on larger deals. Other client data involving Risk Participation Agreements with larger FIs shows a meaningful increase in the use of daily weighted average SOFR (aka simple SOFR).

One consideration or alternative that is often discussed is if the customer or FI has an index mismatch on the contracts. We encourage our clients to be familiar with historical rate differences, quantify potential future rate differences, and compare those differences to any potential savings in the hedged rate. For example, looking at a $25M swap over a 30-day period, a 10 basis point (0.10%) rate differential produces a dollar interest mismatch of just over $2,000.

Many FIs and their customers may opt to not have any mismatch between the hedging contracts, which creates a trade-off between hedge cost savings vs. operational complexity. Servicing overnight SOFR contracts is more operationally intensive and compresses the time from final rate determination to payment date.

The good news is overnight SOFR indices can have rate lookbacks to build in additional processing time. For example, the market standard for daily weighted average SOFR (aka simple SOFR) has a 5-day lookback. This particular index might be a good alternative since it does not have the complexity of compounding calculations (involving (lookbacks or observation shifts).

From a central clearing perspective, the clearinghouses (CME and LCH) can clear SOFR Compound trades with a lookback as well as no payment date lag. For those interested in those alternatives, please note clearinghouses can clear SOFR Compound trades with rate lookbacks but not observation day shifts.

Lastly, many commercial customers may be more familiar with overnight versions of SOFR given the LIBOR transition activities.

Credit sensitive rate (CSR) alternatives

As evidenced from the tables above, we continue to see very light trading on Bloomberg Short Term Bank Yield Index (BSBY) derivatives, and we are still not seeing dealers being able to offer derivatives tied to AMERIBOR. However, we know that both indices are being used for lending purposes and more recently Bloomberg has announced a consultation regarding a proposed cessation of BSBY. It remains to be seen how these indices will evolve and thus used in the derivatives market as well as seeing how the back-and-forth regulatory acceptance plays out.

In conclusion

We believe CME Term SOFR will continue to be the dominant index used in customer hedging programs. However, given the current basis risk and associated dealer pricing, there is a cost premium to consider. There are overnight SOFR indices that provide viable alternatives. It becomes a trade-off between cost savings and operational challenges for both FIs and their customers.

We know how competitive the market can be and we pride ourselves on partnering with our clients, who work tirelessly to investigate different alternatives and provide effective financing solutions to their customer base.

¹ARRC Best Practice Recommendations Related to Scope of Use of the Term Rate

²^,³^,⁴ ARRC Summary and Update of the ARRC’s Term SOFR Scope of Use Best Practice Recommendations