Exploring 3 Major Challenges of the SOFR Transition

In June of last year, the five remaining U.S. dollar LIBOR settings were officially published for the last time. This date marked the final stages of the LIBOR phase out and heralded a new future with alternative risk-free rates, such as SOFR for dollar-denominated derivatives and loans. The market has responded favorably, with daily transaction volume underlying SOFR averaging more than $1 trillion, according to a report by the U.S. Department of the Treasury.  

However, the transition has not been all smooth sailing. As expected, working with SOFR is producing many operational, workflow and market-readiness challenges for financial institutions. Below we share three of the top issues firms are encountering as they navigate SOFR adoption.

1 Need for Upgraded Analytics

Early in the transition away from LIBOR, there was significant buzz around the technology challenges and changes financial institutions would face as they moved to new benchmark rates like SOFR. These included concerns over updates and replacements of trading systems, risk management models and valuation practices. The good news is that the majority of firms Numerix works with have now met these operational and technology-related requirements.

One area, however, where firms are likely to need to invest further in is modernizing their analytics. “To effectively handle the evolving landscape of nonlinear Risk-Free Rate (RFR) instruments, an upgrade and enhancement of the analytics library is imperative,” commented Ping Sun, PhD, Senior Vice President, Financial Engineering at Numerix. “For example, the widely used LIBOR Market Model (LMM) must be adapted to the very different Forward Market Model (FMM). Furthermore, all short-rate models must be capable of calibrating to the RFR-based swaption volatility surface/cube and/or cap volatility surface.”

2 Calculating the SOFR Rate

The transition to SOFR has had a distinct impact on the bond and loan markets. One noted challenge is that daily SOFR, which is paid in arrears, complicates calculating the coupon for bonds and loans, as there is a possibility, for example, that the rate may not be published on the day of a loan payment. This would make it difficult to calculate the coupon and prepare the payment in time. Thus, we might question how vast of a disparity is there when calculating SOFR versus LIBOR?

The reality is that there are significant differences between the calculation methodology for SOFR and LIBOR. Most of the SOFR rates in use follow the compounding-in-arrears approach, which contrasts with the forward-looking LIBOR rate. “Lookbacks and lockout conventions were designed to help solve for these differences,” said Russell Goyder, PhD, Chief Analytics Officer at Numerix. “Persistent challenges in fixing and settling payments referencing SOFR illustrate the tradeoff that the industry has chosen—in exchange for the benefits of IOSCO compliance and protection against manipulation, some cost is paid in operational complexity by users of the new rate.”

3 Liquidity Concerns

Another challenge to the introduction of SOFR and its use as an RFR has been the need for increased SOFR liquidity. While some current headlines in the financial media suggest SOFR liquidity has been improving steadily in recent years, others say it is still an issue. So, is the SOFR liquidity concern behind us or not? The answer may depend on the product you’re trading.

Liquidity in linear instruments, such as swaps, is notably robust, but for non-linear products like swaptions, the story is still evolving. Many consider enabling the use of forward-looking Term SOFR to be a crucial next step, as it is anticipated to enhance associated liquidity. This is attributed to the fact that, in contrast to the daily compounded SOFR rate, forward-looking Term SOFR closely mirrors the nature of LIBOR. Also, forward-looking SOFR rates are often easier to use in financial planning and accounting purposes for market participants.

Get Further SOFR Insight

For more detailed insight on SOFR adoption, including exclusive perspectives from financial derivatives experts, download our related paper: Is Your SOFR Readiness Being Put to the Test? Let’s Talk About Post-Transition Issues and Challenges