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CLOs cushioned as regulators get more comfortable on Sofr
May 2021 | Issue 234
Dan Alderson
Deputy editor
The quest to find a suitable Libor replacement looks to have taken a big step forward in recent weeks, with hopes rekindled that securitised products such as CLOs and ABS could soon make use of a term Secured Overnight Financing Rate (Sofr).
Only weeks ago, in March, the Alternative Reference Rates Committee (ARRC) warned it might not be in a position to recommend a term version of Sofr — the preferred replacement for Libor — by the end of the year. But in two successive days last month — 20 and 21 April — it announced key principles it would use to support a recommendation, and CME Group unveiled a term Sofr aligned with these principles.
“Together, these two announcements suggest that perhaps there is a way forward to term Sofr for those cash products that truly need one, as long as their need does not overwhelm the Sofr derivatives market,” wrote the Loan Syndications & Trading Association in a 21 April blog.
Agha Mirza, global head of interest rate products at CME, believes that securitised products, such as CLOs and ABS, which have fallbacks in the underlying products — ie, loans in the case of CLOs — prefer a forward-looking rate. “We have taken extensive feedback on the design of CME term Sofr, and our three-month Sofr provides a good solution,” he says.
“This term rate is rooted in a robust base of derivatives transactions”
Agha Mirza, Global head of interest rate products | CME
CME will publish one-month, three-month and six-month Sofr term reference rates, based on underlying futures. For CME, the launch has been three years in the making, during which time the demand for term Sofr in the loan and cash market has grown.
“Based on our underlying Sofr futures — which have traded a record $232 billion in representative notional volume on average during Q1 and grew by 82% year-on-year in March — we believe this term rate meets the ARRC criteria of being rooted in a robust and sustainable base of derivatives transactions over time, and with a limited scope of use,” says Mirza.
Various solutions are being teed up to help deal with the transition. For example, IHS Markit has worked on a credit spread adjustment to address a key difference in the behaviour of Sofr, which is based on secured repo transactions. As part of its efforts to provide risk management solutions for market participants, CME is also collaborating on the Bloomberg Short Term Bank Yield credit sensitive index.
“There are two sides to how the market’s application of Sofr solutions will evolve,” says Mirza. “On one hand, a small set of strong liquidity pools would be beneficial, but on the other we live in a diverse economy where sufficiently different products need to exist to serve client needs. The market will naturally seek a healthy balance between these ideas.”
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Global credit funds & CLO's
May 2021 | Issue 234
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