Spat over Toyota deal stalls vote on easing term SOFR curbs

ARRC concerned by use of forward rate in securitisations, stands firm on swaps restrictions

A proposal to expand the use of a term version of the secured overnight financing rate (SOFR) in derivatives appears to have been shelved, after use of the benchmark in a recent securitisation from Toyota drew an angry response from the Federal Reserve-backed group tasked with steering US markets away from Libor.

The Alternative Reference Rates Committee (ARRC) was expected to recommend a limited expansion of term SOFR use in derivatives at its meeting on November 9. The proposed change to the guidelines would have allowed fixed-rate issuers and buy-side firms to hedge their rates exposures with the forward-looking rate.

Instead, the meeting was dominated by debate over a $293 million term SOFR tranche in Toyota’s latest $1.5 billion auto loan securitisation, issued the previous day.

“It certainly was a lively discussion,” says a source familiar with the meeting, which concluded without the proposal to expand the use of term SOFR swaps being put to a vote.

A readout of the meeting states: “The ARRC expressed concern about some recent trends, such as securitisations using term SOFR when they did not have underlying term SOFR assets, that were outside the scope of the ARRC’s best practice recommendations.”

The ARRC’s guidelines permit the use of term SOFR in securitisations “that hold underlying business loans or other assets that reference the SOFR term rate and where those assets cannot easily reference other forms of SOFR”. The auto loans underpinning Toyota’s asset-backed securities are fixed rate.

A Toyota spokesperson did not respond to a request for comment in time for publication. A spokesperson for the ARRC declined to comment beyond the readout.

The deal – underwritten by Barclays, JP Morgan, RBC Capital Markets and SG Americas – is widely seen as the first major test of the ARRC’s guidelines.

The ARRC expressed concern about some recent trends that were outside the scope of the ARRC’s best practice recommendations

Meeting readout

“The leads appear to have tried it out. If you get a good investor response, it kind of forces the hand of the ARRC and therefore the Fed. I think it was a test,” says John Feeney, a partner at Martialis Consulting in Sydney. “It’s fairly clear there’s demand for term SOFR on both sides – both borrower and investor – for their own good reasons.”

The underwriting banks declined to comment.

Members of the ARRC and Fed officials at the meeting are said to have been taken aback by the terms of the Toyota transaction. “It seemed odd, and I was surprised someone went ahead with that,” says the source familiar with the meeting. “The ABS market has been chugging along fine, just like the FRN [floating rate note] market, with overnight in-arrears or in-advance SOFR, which are perfectly stable constructs, for the better part of nine months with no complaint.”

Others accuse the ARRC of overreacting. “It seems like a big hullaballoo,” says a US-based structured finance banker. “They [the ARRC] say they’re concerned, but they don’t spell out or say why they’re concerned.”

Term limits

The outcome of the meeting is a major setback for dealers that have been calling for restrictions on the use of term SOFR in derivatives to be relaxed.

Term SOFR has emerged as the preferred replacement for US dollar Libor in loan markets, but the ARRC’s guidelines limit its use in derivatives markets to direct hedging of cash products referencing the rate.

This has resulted in a one-sided market, with term SOFR swaps trading at a premium to compounded-in-arrears versions, which dealers must use to hedge their exposures. The basis currently sits around 2bp to 3bp, though it can vary dramatically. Without interdealer trading and broker screens, pricing of term SOFR swaps remains opaque.

The ARRC reconvened its term rate task force in June to address dealer concerns about the market for term SOFR swaps. Two sources tell Risk.net the task force was poised to recommend an easing of the guidelines to permit wider buy-side participation and encourage two-sided trading.

That proposal still falls short of dealers’ demands to allow a fully fledged interdealer market in term SOFR swaps. At a June industry event, JP Morgan’s assistant general counsel Tamsin Rolls said allowing dealers to hedge themselves with term SOFR swaps would improve the availability of term SOFR hedges to end-users.

Goldman Sachs is also said to have adopted a similar stance. A spokesperson for the bank declined to comment.

Visibility issues

The restrictions on term SOFR swaps means there are no electronic price streams for the instruments, which has widespread implications for bank balance sheets and could ultimately restrict their ability to offer the products. US accounting rules require banks to bucket derivatives according to their liquidity profile. Level 1 assets must have a clear mark-to-market mechanism for valuation. Most dealers treat term SOFR swaps as Level 2 assets, for which fair values can be interpolated from other instruments, while some classify them as Level 3 assets, which are valued using models and assumptions.

Without visible pricing, banks must house the instruments in exotic or structured books, which attract higher capital charges under the Fundamental Review of the Trading Book.

“Keeping these instruments on the structured book is the real cost. It’s an add-on over which they have no control which is causing the most angst and which they are passing on to clients,” says Martialis Consulting’s Feeney.

If the ARRC permits an interbank market in SOFR swaps, the boost in pricing visibility means dealers will be able to move these exposures into their trading books, which receive better capital treatment.

The ARRC said in its readout that discussions over expanding the use of term SOFR in derivatives would continue: “The ARRC reiterated its existing best practice recommendations and plans to continue to assess the use of term SOFR as part of its ongoing work related to term SOFR’s recommended scope of use.”

But some believe the ARRC was already veering away from softening its use cases even before the furore over Toyota’s securitisation. “In conversations we’ve had, they’re not suggesting they’re going to back down,” a senior rates trader at a European bank told Risk.net before the meeting.

The trader is now resigned to the restrictions remaining in place, but warns of potential dangers ahead. Trillions of dollars of Libor-linked cash instruments and their related hedges will automatically switch to term SOFR under federal legislation when Libor ceases in June 2023.

“Banks will end up warehousing that basis, and when you warehouse a wrong-way position, something’s going to go wrong,” the trader says. “Regulators should be conscious of that, but at the moment they’re pretty firm they don’t want an interbank market,” says the bank trader.