Treasury Issuance Could Aid Adoption of SOFR Benchmark

It has been almost a decade since the revelation that certain banks were manipulating the London interbank offered rate (Libor), a key benchmark for corporate borrowing worldwide. Since then, regulators globally have pushed to phase out Libor and replace it with new standards. In the U.S., the secured overnight financing rate (SOFR) has been established as the heir to Libor, but progress in the transition has been slow.

Along the way, the U.S. Treasury has been considering whether to issue floating-rate notes based on SOFR. We think initiating such issuance would let the Treasury use its immense platform within bond markets to lend credibility to the new reference rate, as well as to foster needed growth in the trading of SOFR-linked debt and derivatives. It would also expand the options available to address both U.S. borrowing needs and investor demand for floating-rate instruments.

Slow transition

The Federal Reserve and other global regulators have pushed to do away with Libor, which represents an estimate of the average interest rate a bank would be charged by other banks for an unsecured loan for a certain period. By contrast, SOFR – a measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities – is calculated using Treasury repurchase agreement (repo) market data and has been published daily by the New York Fed for the past two years.

To hasten the transition in the U.S., the Fed has set a timetable for new contracts based on Libor to be phased out by year-end, while existing ones are slated to sunset in mid-2023. Yet even as its demise draws nearer, Libor remains the prevalent benchmark rate in markets for derivatives such as futures, options, and interest-rate swaps.

Institutions have hesitated to be early adopters in a nascent SOFR market that lacks the broad-based liquidity of Libor-linked instruments. The longer they wait, the greater the risk that rival standards could take root, potentially splitting the market. Alternatives such as Ameribor and the Bloomberg Short-Term Bank Yield Index have received attention in recent weeks as potential challengers to SOFR.

Issuance gap

Although issuance of SOFR-linked debt has been underway, it’s been largely limited to financial firms, with the first corporate deals emerging this year and no sovereign offerings. After a concerted effort by U.S. agencies including Fannie Mae and Freddie Mac to sell SOFR-linked securities a year ago, issuance has been gradually declining (see chart below), while derivatives volumes have only moderately increased in the past few months.