SOFR and the Shutdown of Overnight Repos: What Happens If There Is Nothing to Measure?

As discussed in my earlier blog “‘Measure for Measure:’ LIBOR, SOFR, and the ICE Bank Yield Index”, over $300 trillion of derivatives, loans, and other financial products have floating interest rates based upon the London Interbank Offering Rate (“LIBOR”).

LIBOR to SOFR

The LIBOR pricing system grew organically from arrangements made among market participants, primarily the leading banks in London (not all British). These arrangements were formalized in October 1984 (a prescient year) by the British Banking Association with the active support of the Bank of England. Fundamentally, each of the participating banks (some 18 in 2008, including three U.S. institutions) would call in with an estimate of what that bank could borrow for a fixed time period (typically 3 or 6 months).

Then in May 2008, The Wall Street Journal released a study suggesting that participant banks were understating the interest rates at which they could borrow, thus making those banks look financially stronger than, in fact, they were. The revelations led one British financial leader to describe LIBOR as:

“The rate at which banks don’t lend to each other.”

After lengthy studies and investigations, the British Banking Association conveyed all rights to LIBOR to the Intercontinental Exchange in 2013 for one euro. In July 2017, the U.K. Financial Conduct Authority announced LIBOR would end by 2021. In the United States, the Board of Governors of the Federal Reserve System (“FRB”) created the Alternative Rates Reference Committee (“ARRC”) to find a replacement for LIBOR. ARRC has (to date) appeared to settle on the Secured Overnight Financing Rate (“SOFR”). SOFR is based on actual transactions involving the pledge of U.S. Treasury securities to secure repurchase agreements by banks. The view was: as SOFR would be based on actual transactions it would be insulated from manipulation by the participant banks.

What would happen, however, if, for some reason, banks ceased to be willing to lend funds overnight to other banks, even if the transactions were secured with the pledge of U.S. Treasuries?

Could such an event occur? What would happen to borrowing costs? In the third week of September 2019, major U.S. banks suddenly became quite adverse to lending funds to other banks on a secured overnight basis. There was a potential for serious disruption in the financial markets. The result of this mysterious aversion was that the cost of borrowing overnight rose from about 1.75% on September 13 to 5.25% on September 17 before the infusion of short-term funds by the FRB calmed the market back down to 1.86% on September 20. For at least this brief period, SOFR would have been a vastly different “measure” from that which the ARRC intended.

Some financial leaders, including one employed at a major U.S. bank, was cited as observing that using a 90-day average SOFR moved only 0.02 percent. Others, including an executive at the Bank of America, were less sanguine. Then the financial press reports that on November 7, the FRB elected to inject $115.4 billion into the financial markets - $80.1 billion for overnight repos and another $35 billion in 14-day repos. These injections are:

“Aimed at ensuring that the financial system has enough liquidity and that short-term borrowings remain well-behaved.”

So, how well-suited does SOFR appear now?

If you have any questions about this post or any other related matters, please feel free to contact me at pdhutcheon@norris-law.com.