The benchmark being eyed as a potential replacement for dollarLIBOR (the London interbank offered rate) is facingrenewed scrutiny after a year-end surge in the market underpinningthe new rate. With more volatility possible, Wall Street isincreasingly wondering if the nascent Secured Overnight FinancingRate (SOFR) will be up to the task.

Last month's jump in rates on overnight Treasury repurchaseagreements—the market that supports SOFR—pushed the benchmarkhigher by almost 70 basis points over a two-day span. It has sinceretreated and was set at 2.43 percent for Wednesday. But given thatboth repo and SOFR are also susceptible to swings in Treasury-billsupply, which itself could become more erratic as the U.S. grappleswith the reintroduction of the debt ceiling, some market veteransare forecasting further fluctuations ahead.

Concerns about SOFR range from a lack of term structure to tepidvolumes in derivatives that are tied to it. And that has tradersand strategists saying the new rate needs to make significantheadway in 2019 if U.S. regulators expect it to eventually take thebaton from LIBOR, which still underpins more than $200 trillion ofdollar-denominated instruments.

“It's good to learn we have these issues, but it also suggestswe should be looking for something else,” said Ward McCarthy, chieffinancial economist for Jefferies LLC. Regulators have “really haveput a lot of work into developing this and trying to garneracceptance of it. But the bottom line is performance.”

That's not to say the benchmark, administered by the FederalReserve Bank of New York, is doomed. The U.S. Treasury is exploringthe prospect of selling SOFR-linked notes. Issuers running thegamut from government agencies to banks and municipalities havepriced more than $30 billion of debt tied to the reference rate sofar.

And the International Swaps and Derivatives Association(ISDA)—along with other industry groups—is pushing ahead onfallback language for contracts still tied to LIBOR. In addition,it appears a near certainty that there will be further regulatoryefforts to promote greater adoption ahead of LIBOR's intendedphase-out by the end of 2021.

See also:

• LIBOR Replacement Contenders
• A New LIBOR Rival Emerges
• LIBOR's Heir Presumptive Prepared to Take on BankBond Market

Here's where SOFR stands as its quest for credibilitycontinues:

The Headwinds

Underlying volatility. Funding rates surged at the end of 2018, spurred by a combinationof primary dealer balance sheets loaded with Treasury collateraland a regulatory-induced pullback by those firms from the repomarket. SOFR was among the rates sent soaring, and although thebenchmark has largely printed in line with expectations since itsdebut, this recent bout of volatility underscores how fundingconditions could rile the rate going forward.

The susceptibility of repo rates to swings in Treasury-billissuance and expectations for seesawing supply surrounding the U.S.government's debt ceiling may inject more instability. In anenvironment where banks are reducing their excess reserve balances,“repo rates, and consequently SOFR, will likely only become morevolatile,” JPMorgan Chase & Co. strategists led by Alex Roeverwrote in a note earlier this month.

Term structure impediments. Because SOFR is derived from overnight repo transactions, there isno term structure similar to that of LIBOR-based derivatives.Instead, SOFR futures are derived using a compounded calculationover the prevailing period—either three months or one month. Thiscould make market participants more wary of using SOFR-derivedproducts, depriving these nascent contracts of depth andliquidity.

Lack of volume.  In its pacedtransition plan, the Alternative Reference Rates Committee (ARRC),which is tasked with developing and implementing SOFR, said thatincreased trading activity in derivatives tied to the benchmarkwill facilitate the creation of an indicative term structure. Yetvolumes in both futures and swaps remain tepid. Total open interestin three-month SOFR futures contracts is roughly 30,000, down fromabout 42,000 on Dec. 18. On the swaps side, there were 52SOFR-linked trades in 2018 totaling $6.3 billion in notional value,ISDA data show. There were more than 600,000 LIBOR-based tradestotaling roughly $111 trillion in notional value over the samespan.

“It's hard to create liquidity from no liquidity,” said DarrellDuffie, a professor at Stanford University who is working with theARRC on a mechanism for converting LIBOR swaps to SOFR swaps.

The Tailwinds

The FHLBs are showing up. Even as some market participants remain wary about adopting SOFR,others are plowing ahead. On Jan. 15, the Federal Home Loan Banks(FHLBs)—the largest issuers of short-term LIBOR-tied debt—sold$2.75 billion of SOFR-linked notes in a two-part offering. It's theentity's third deal since November.

The first SOFR-tied floaters from issuers such as the FHLBs thatcome under the aegis of the Federal Housing Finance Agency havebeen the “beginning of an intimate dance of what these bonds aregoing to look like,” according to Jack Phelps, the principalexaminer at the FHFA.

Enter Treasury.  The U.S.government is examining how issuance tied to the new benchmarkcould fit into its overall debt strategy. In a questionnairereleased ahead of the Treasury's quarterly refunding announcementlater this month, the department asked primary dealers for theirperspectives on the potential debut of issuance tied to SOFR.Specifically, the Treasury asked whether SOFR-linked debt wouldbroaden and diversify its investor base, or reduce demand for andliquidity in existing securities. Should the Treasury decide toissue SOFR-linked debt, strategists say it would be a major steptoward facilitating wider adoption.

Pressing forward.  Despitemarket participants' reservations, regulators and industry groupsare still preparing for the end of LIBOR in just under three years.The ARRC expects to introduce an indicative term rate sometime inthe first quarter, according to spokesman Andrew Gray, and thecommittee is also soliciting feedback on fallback language forbilateral loans and securitizations.

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