Q&A with ARRC’s Tom Wipf: the shift to term SOFR

By CME Group

At a glance

• The selection of CME Group’s Term SOFR rate “fills the gap,” for multi-lending facilities, middle market loans and trade finance to transition from LIBOR, says ARRC chairman
• Wipf explains how Term SOFR will help reconcile legacy contracts and shift $225 trillion in LIBOR contracts into SOFR CME Group’s Secured Overnight Financing Rate (SOFR) Term Rates have seen extensive client interest since the Alternative Reference Rates Committee (ARRC) endorsed them on July 29, with the move marking the last step in the ARRC’s Paced Transition Plan from LIBOR. SOFR Futures activity at CME Group increased following the announcement as well, moving from an average daily volume of 118,000 in Q2 to more than 146,000 in August. In an interview with OpenMarkets, ARRC chairman and vice chairman for Institutional Securities at Morgan Stanley, Tom Wipf, shares insights into the decision behind the committee’s selection of the CME Group’s 1-month, 3-month and 6-month term rates. He also details which firms are benefiting most from their roll out and explains how Term SOFR will help reconcile legacy contracts and shift$225 trillion of LIBOR contracts (a “barge of liquidity waiting at harbor”) into SOFR.

The interview has been edited for length.

Why did ARRC choose CME Group’s Term SOFR?

Tom Wipf: The ARRC identified CME Group’s submission as the strongest proposal to administer Term SOFR after a thorough evaluation. The process around it was straightforward and transparent. We evaluated proposals based on four specific criteria: technical criteria, firm criteria, public policy criteria and calculation methodology criteria. After a lot of work from our working group and the entire ARRC team, we identified CME Group’s proposal as having most effectively met those criteria.

What kind of clarity does this give the interest rate market? Who are the entities that were especially in need of a term rate?

Wipf: We have been very focused on lending markets that have had more trouble in transitioning from LIBOR. For instance, many markets, like derivatives, are used to utilizing compounded SOFR. Additionally, when we looked at certain markets that needed this term component and that required payment certainty, we looked at business loans, securitizations and many other areas that were having trouble transitioning.

We wanted to be cautious because there are some markets, such as floating rate notes, that have become accustomed to using the compounded overnight rate. We tried to fill the gap, which is why I think the CME Term SOFR is going to be so important to particular areas where we came out in support of its use. Multi-lending facilities, middle market loans and trade finance are a few that will benefit greatly as their transitions have been more difficult.

How important is the term rate for the purposes of the legacy products space?

Wipf: It’s incredibly important. If you look at everything that has been traded under ARRC fallback language or products that would rely on New York State legislation (and hopefully federal legislation), all of the ARRC fallback language in cash products has been used and that is the first step of the waterfall. The CME Term SOFR rate will be first step for many trillions of legacy products – including those that to go past June 2023.

You’ve said this means market participants now have all the tools they need. What’s left in the homestretch of the transition to SOFR?

Wipf:  In everything we laid out way back during our paced transition plan, there were a series of deliverables we needed to bring to market. This final recommendation of CME Term SOFR was the last piece of that puzzle, and market participants now have all of the tools they need as we enter into the transition’s homestretch. We can see that what has helped us here is the alignment of CME Group with the ARRC’s principles. This was important because there are so many lending markets that were much more complicated, oddly enough, than the derivatives market, which dominated this discussion in terms of notionals.

Now we are entering the homestretch, looking at no new LIBOR by end of this year. We hope market participants will have enough time to get these rates through modeling and into their systems. We believe it was the best choice to complete the work in the time allotted, which is why the formal recommendation of Term SOFR was such an important milestone for us to meet.

Describe the importance of price transparency and liquidity in helping SOFR gain acceptance.

Wipf: Going back to the original plan, the work CME did in developing the SOFR futures market and the exponential growth across that gave us a lot of confidence that we will see this further down the road in swap markets and other uses of SOFR.

The SOFR First initiative was the first step to supercharging liquidity in the inter-dealer market, which set us up to do two things:

First, bring clients in. We had many buy-side clients who would have preferred to use SOFR because they knew there was going to be a liquidity drop in LIBOR as we approach year-end, but felt they were paying a premium to do so. The more liquidity we get in SOFR in all its forms, the more that liquidity can attract additional liquidity.

The idea of greater price transparency, access, liquidity (which really began in October with the CCP switch on discounting from LIBOR to SOFR) gets us to this point. We are now entering the last innings equipped with everything any market participant should need to complete the work.

SOFR futures have developed rapidly and surpassed 600 institutional participants. How might the SOFR First initiative and selection of term SOFR reference rates help develop other parts of the SOFR ecosystem?

Wipf:  With liquidity building widely across many products, I expect it will become the market standard. We don’t want to forget that there is an enormous amount of liquidity waiting out there until June 2023. 99% of every contract that will flip through fallbacks at the end of LIBOR will go to SOFR. We describe it as this barge of liquidity waiting at harbor that will bring us there. So when you think about your entire book of business, particularly for large market participants, you have a legacy book of derivatives, cash products and other things that will flip to SOFR, whether overnight or term, at end of LIBOR.

And if you look at our last ARRC report, there is \$225 trillion in contracts (67% rolled down before June of 2023) and that leaves a pretty nice chunk of liquidity on anything that is going to flip or go through fallbacks. What we really need to do is build that bridge to June 2023 across the entire ecosystem -  because the minute we get to the homestretch, there’s trillions and trillions of liquidity that will lead us toward completing this work in a great way.

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