With less than a year until the anticipated sunsetting of many global interbank offered rates (IBOR), the Alternative Reference Rates Committee (ARRC) has recommended the Secured Overnight Financing Rate (SOFR) to replace USD LIBOR. Since its emergence in 2018, some liquidity in SOFR-linked financial instruments has developed, but many legacy products and industry segments are struggling to adapt to the new rate.
As a leading index provider with a strong credit franchise, IHS Markit is well-positioned to help the industry overcome the challenges presented by SOFR – specifically by addressing the differences in a secured versus unsecured rate.
With this in mind, IHS Markit is developing a USD credit spread adjustment which utilizes transaction data on commercial paper, certificates of deposit and corporate bonds issued by banking institutions. IHS Markit expects to deliver and publish the daily USD credit spread adjustment to the market beginning in the second quarter of 2021.
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Addressing Industry Concerns
There are two main concerns raised by financial institutions on the transition towards SOFR:
1. The first concern is that SOFR is an overnight rate, whereas USD LIBOR is a term rate. To use SOFR in financial contracts, the overnight rate must be compounded to a term, typically in arrears, which is a major change to the way financial instruments are booked and priced today with USD LIBOR.
2. The second concern is that USD LIBOR embeds a bank credit component. SOFR does not have this credit component as it is based on secured repo transactions. This concern gained additional focus in spring 2020 due to the market volatility experienced during the COVID-19 pandemic. In times of market distress, USD LIBOR will tend to widen whereas SOFR will tighten. To be compensated, lenders need to adjust secured reference rates so that they include a credit risk component of borrowers or issuers. This credit risk component must also move in line with market dynamics so that credit exposures are properly captured in financial instruments over time.
“In order to achieve a timely, smooth and successful transition to SOFR, some market participants will need an alternative mechanism to capture the dynamic credit component that is embedded within USD LIBOR,” said Julien Rey, executive director and global IBOR transition lead at IHS Markit. “Credit markets move independently of interest rates, at times in opposite directions, and in the post-LIBOR era, it will behoove banks and borrowers engaged in lending activity to include a credit spread adjustment that reacts in a timely manner to credit markets. The credit spread will help ensure lending activity does not veer too far off-market.”
IHS Markit will use an advanced adjustment methodology paired with robust and timely market data to deliver a successful credit spread. This approach complements the imperative to draw upon a deeper, more diverse data set; including additional institutions results in a more holistic view of the market and directly addresses concerns that looking only at the LIBOR Panel Banks will not be inclusive enough.
Additionally, dynamic thresholds ensure our methodology reacts to changes in funding behavior programmatically and does not rely on arbitrarily selected rigid thresholds. Our fallback methodology is designed in a manner so that a credit spread will be published daily. The result: a robust and reliable credit spread adjustment that brings market participants the flexibility to apply a spread to the rate component of their choosing, such as compounded SOFR or a term rate.
Source: IHS Market