SOFR vs BSBY term in the loan market | Moore & Van Allen SARL
On Wednesday, the ARRC announced (HERE) the wait to endorse SOFR term of CME late July or early August. One of the most important elements of this announcement is the announcement that US regulators will also allow Term SOFR Swaps, when one of the parties is an “end user”. Looking only at the loan market, which new benchmark rate will be the most common? SOFR term, BSBY or one of the other SOFR tariffs? Some thoughts below, but at this point I think lenders need to start thinking about how rate options will be discussed with borrowers. We have worked with clients to develop advice on this topic, which is complicated given that such discussions are problematic under banking regulations and CFTC swap regulations.
The “winning” rate will be the swap with the lower fixed rate
As I have mentioned in the past, I would expect the rate most commonly used by lenders to be the variable rate which can be exchanged for the lower fixed rate. I guess most borrowers will be less focused on the nature of the variable rate and more focused on the cost of any hedging.
I’m not sure term rates are of much use in the loan market today. Maybe if borrowers notice that the forward SOFR traditionally overestimates the daily simple SOFR, then borrowers will head to the daily simple SOFR? SOFR Term> Daily Simple SOFR should be the case, since the SOFR term should align more closely with the SOFR Compounded In-Arrears. Is this delta enough to make a difference for a borrower? Alternatively, if the borrower has no problem with handling Daily Simple SOFR’s payment requirements, then they may prefer that rate today. I just haven’t seen or heard of too many borrowers wanting to get an arrears rate.
SOFR forward swap issues – Dealers will have mismatch issues
Although a lender can combine a SOFR term loan and a SOFR term swap, the lender will now hedge the SOFR term swap with a SOFR compound arrears swap. There will be a lag here. This lag can increase the costs (i.e. increase the fixed rate) on an SOFR term swap, so that the lender can capture a profit that will be used to cover the risks associated with this lag. Alternatively, a lender can find other methods to internalize this risk. Overall, this should be a priority for lenders to determine how this mismatch will be resolved. The floating amount received by an exchange provider based on SOFR compound arrears should be close to the amount owed by the exchange provider on a forward SOFR payment amount for a similar term / calculation period, but it will not be equal to 1 to 1..
BSBY – No lag, but liquidity is still uncertain
BSBY should not have the risk of asymmetry – that is, the variable rate in the borrower’s swap and the dealer’s market swap can be exactly the same. However, it is still unclear what liquidity will look like in the dealer-to-dealer market, which has an impact on prices. SOFR benefits from the support of the ARRC and the CFTC’s “SOFR First” best practices, which should promote growth in a SOFR swap market. Even though SOFR forward swaps present a mismatch risk and this risk has an impact on prices, the impact on prices may be minimal due to SOFR liquidity already creating tighter spreads and lower prices. Finally, if SOFR swaps have a clearing requirement and BSBY swaps are never cleared, this could also have a huge impact on the market. I know banks tend to prefer to hedge their borrower face swap portfolio with cleared swaps, but if BSBY swaps are not clearable, that may or may not impact BSBY adoption. Since exchange traded swaps really go hand in hand with netting, SOFR swap trading on the exchange could benefit more from SOFR pricing.
In short: BSBY will have no risk of lag. In the broker-to-broker market, SOFRs can have greater liquidity and are compensable. It will be interesting to see which one has the best price for the swaps against the borrower. Additionally, as discussed below, dealers may not hedge a BSBY swap any differently from a forward SOFR – i.e. both borrower swaps are valued on the basis of the fixed rate on the SOFR market from concessionaire to concessionaire? If so, maybe the “fixed rate” of the borrower’s swap is independent of whether the variable rate is BSBY or SOFR forward?
Small banks – Can they use the term SOFR in swaps with their concessionaire + liquidity provider?
A bit of background: Small banks can choose an offsetting exemption, commonly referred to as an “end-user offsetting exemption”. Also, many of these smaller banks actually execute 1 to 1 between a borrower’s swap and the smaller bank’s hedge that is a swap broker’s counterparty.
What is an “end user”?
The above question is really much broader. There are companies affiliated with the Treasury, special securitization vehicles, cooperatives and other entities whose business is primarily to engage in financial activities, but who consider themselves to be “end users”.
Not all end users make widgets. The most recent margin rules for swaps have extended what long-side entities believe are eligible for “end-user” treatment. We should get more clarity on this, and I hope / hope he will follow buyers exempt from US swap margin requirements.
Small banks will use BSBY?
If small banks don’t qualify as “end users” then I would expect them to prefer BSBY. Not only does this more closely match their cost of funds, but (1) they’ll want a 1-to-1 match and (2) they likely won’t have systems in place to confirm any compounded arrears calculation or otherwise simply prefer not to. not have cash flow management based on this type of variable rate calculation.
Credit sensitive rates other than BSBY?
I just didn’t see much in Ameribor. Honestly, all of these talking points on BSBY apply the same to any other CSR like Ameribor, but at this point it looks like other CSRs aren’t picking up, which also means it’s more likely. that they will have a higher cost of coverage. So rather than constantly referring to “credit sensitive rates”, I stick with BSBY in case there are any nuances unique to this rate.
Regulatory issues with BSBY?
I have participated in various industry and sight calls: There is no regulatory risk with BSBY – that is, no bank or other regulator will make BSBY illegal or otherwise disappear, with the aim of promoting SOFR. It seems that many people other than me were also very critical of Gensler’s comments, deeming them to be misleading / inaccurate.
Are there other reasons to prefer BSBY over SOFR, or vice versa?
Yes. If it only focuses on a loan portfolio, the SOFR term will (probably) always be lower, but that’s why the “SOFR adjustment” is there. Lenders may want to start comparing the BSBY rate against the SOFR adjusted forward rate. This could be useful information for a loan bureau when talking to borrowers. Alternatively, if we ever see rates rise, then the BSBY may be higher than an agreed adjusted SOFR in a low interest rate environment.
Having said that, much smarter people than me have most likely already thought about this one and can discuss forward curves for both rates.
SOFR is also manipulated by the Federal Reserve, so in times of stress, the Fed may force this rate down and hold it. The SOFR adjustment is meant to help, but the interest rate environment over the past 5 years (the period on which the adjustment is based) is unique when considering a longer window. In previous emails I have talked about market shocks where SOFR falls below the cost of funding, but it should also be noted that SOFR is not so much a rate purely based on free market activities, but a rate that the Fed can manipulate and has before (HERE). Yes Jay Pow Keeps Brrrrring Fed Printers, he and the future Feds will keep SOFR low.
An artificially low SOFR could negatively impact a loan portfolio that might otherwise perform better if the same loans were priced based on BSBY or another CSR. On the other hand, the more an institution is exposed to swaps, the low interest rate environment would increase the likelihood that borrower swaps are in the money for banks (but the bank’s portfolio hedges are out of range. change, so it can be a wash).
Overall, the more I look and think about the two rates, it seems that a bank is “best positioned” if it has both SOFR and BSBY exposure.
On swaps, if BSBY and the adjusted forward SOFR are supposed to follow each other roughly (because both are an approximation of LIBOR), maybe a swap bureau feels comfortable not caring if Is the borrower’s swap SOFR or BSBY forward for pricing purposes, as any effort to hedge / price this risk will depend on the fixed rate in the SOFR compound arrears market from concessionaire to concessionaire?
Right now, it might be best not to put all your eggs in one basket.