It’s been amazing to watch SOFR do in real-time what its detractors had warned about the entire time. The Federal Reserve through its various means pushed the private market to adopt this thing after having demonized LIBOR for going on a decade. Why? Not any crime, the truth is LIBOR is a eurodollar rate that far better represents the monetary system as it really is.
And what that is isn’t the easy stuff they teach in all the Economics textbooks. Real money is horribly complicated, geographically expansive, and bank- rather than central bank-effective.
In school, you learn all about the Fed and its wondrous capacities which we’re taught very easily manipulate and at times control every facet of money therefore finance and economy. There are open market operations, rate targets, new-ish programs like RRP and IOR (they dropped its “E” a little while back).
They even teach you about something called “moral suasion”, a part of the policy toolkit that policymakers lean very heavy upon. While the markets looked to LIBOR, central bankers like to depend on words.
Most of those are spent attempting to describe what all those other tools are meant to do, with almost none used to recount what any actually have done. The few which are delivered in the latter capacity start from a suspiciously careful tone if only because what each says is universally underwhelming; a true disconnect.
If enough of the public, perhaps a few inquisitive rather than corrupt politicians were to put two and two together they’d quite easily find the entrance to the rabbit hole otherwise visibly located in the LIBOR suite. What words can match the tens of trillions in this the eurodollar’s world?
You’re not supposed to ask that question, thus the real emphasis behind SOFR. Bury LIBOR so as to benchmark US$ credit in domestic US$ finance making it once more appear as if all falls under the Fed’s seemingly expansive monetary umbrella.
No wonder it isn’t going so well. In what has been a very rocky year – to put it mildly – the SOFR saga has turned out predictably failing. There have been three (so far) clear and discrete outbreaks of monetary strain: around mid-March; again near mid-June and after; then a big one mid-September which invited more than casual scrutiny (not just in places like London and Switzerland).
If the pattern holds…mid-December. We’ll come back to that.
During these periods of distress and growing disorder, LIBOR (including the indispensable TED spread) priced those rising risks. SOFR did, too, but underwhelmingly. In the world of huge finance where pricing billions, hundreds of billions even trillions of instruments of all kinds benchmarked for reasons of information about risks, not trusting the benchmark can only lead to deep, deep problems.
Over the longer run, loans won’t get made and those which do might be pricier because of this unnecessary uncertainty. However, we won’t be able to see the full effects of that for some time.
In the shorter-term, what we have is this blatant discrepancy. SOFR was meant to replace LIBOR meaning a good enough substitute for it. Yet, SOFR is an overnight rate cobbled together from actual transactions drawn from various domestic repo sources. LIBOR is an unsecured and offshore, which are entirely different aspects.
Furthermore, LIBOR isn’t a single rate rather a whole array of them giving the suite an innate term structure. For SOFR, the market is supposed to imply a term structure from futures trading.
For all these problems, banks - particularly regional banks in the US - rather than the dealers who’d be on what I’d say would be the side to benefit from SOFR adoption complained strenuously about what they knew could (would) become a true impediment to beneficial loan and credit production. Ten of them even went so far as to write a formal letter to regulators detailing serious apprehensions:
“During times of economic stress, SOFR (unlike LIBOR) will likely decrease disproportionately relative to other market rates as investors seek the safe haven of U.S. Treasury securities.”
Yep, that’s just what has happened. For the monstrosity of term SOFR, because it is anchored to an assortment of overnight repo rates, this replacement benchmark has underpriced short-term money rates relative to whichever tenor of LIBOR. In mid-November, for instance, the difference between 3-month term SOFR and 3-month LIBOR was more than 40 bps!
Not only that, this spread appears and widened the most during those sequential times I laid out before. Whenever monetary strain shows up, right when you’d want credit benchmarks to be at their most informative, that’s right when SOFR does instead what those ten banks warned about.
It isn’t just because of “safe haven” demand for USTs, either. Repo rates have softened on those occasions for lack of easily available USTs as collateral in repo.
In other words, cash lenders have trouble finding borrowers who have access (not necessarily own) to USTs as the best collateral. More lenders per those borrowers who do leads to competition among the lenders for a smaller pool of acceptable borrowers, forcing rates to sink relative to others where collateral isn’t such a dominant influence.
Like LIBOR, where it isn’t a consideration at all.
Lower repo rates can soften SOFR which translates into less term SOFR than whatever term for LIBOR. For the record, this was no idle speculation on the part of the disgruntled banks being forced to accept this alternative, those ten regionals didn’t just get lucky with their complaint. Unlike the public which has been kept in the dark, financial firms forced up close to various and repeating dollar crises have repeatedly observed this behavior.
A crucial yet unappreciated aspect of the Great Monetary Crisis of 2008 was this same distancing between repo rates (which fell) and the various LIBORs (which all rose). We’re all told via official wording, too, that if rates go lower that’s a good thing when in practice it can be, and often has been, the opposite.
In a nutshell, it has been decided it will be easier to get rid of LIBOR than fix the actual problem.
Just not without the undocumented costs like those being imposed in 2022. As I write this, SOFR sits at 3.80% which is the same as the Fed’s RRP. That’s already low, but there’s another catch even here: FRBNY’s Broad General Collateral Rate (BGCR) and Tri-party General Collateral Rate (TGCR) both are at 3.76%. The pair are where the SOFR calculation begins.
Not only are they appreciably less than RRP – therefore indicating the situation I described just above – they’re below SOFR. Simple arithmetic says the difference must be in some other part of the SOFR scheme, which is something called DVP, or delivery-versus-payment.
One more untold complication is how repo isn’t as neat and tidy as SOFR might make it sound. There are parts of repo which get very little light of day. In fact, the majority remains in the shadows of bilateral bespoke transactions between only the (cash or collateral) borrower and (cash or collateral) lender, with sometimes a dealer in between brokering the otherwise opaque transaction.
I’ll point out here that certain official studies claim that the balance of repo is nowadays tilted in favor of on-exchange transactions like tri-party repo. The assertion is at least highly arguable, and, for what it’s worth, I am far from convinced that is the case.
DVP repo captures some of those visible segments, though SOFR doesn’t always treat it equally, either. Without going too far into the specifics of repo “specials”, essentially for putting together SOFR, FRBNY takes BGCR and TGCR general collateral rates then throws in volume-weighted DVP (which is made up of both general as well as specific collateral rates) but only after dropping the lower 25%.
The point is to try to remove any influence from specific repo collateral securities which are trading special, meaning individual instruments seeing high demand for reasons that may not have anything to do with money market conditions (such as specific securities being shorted by speculators who need to borrow them, therefore are willing to lend their cash in repo at lower and lower rates for anyone who has access).
There are times when the lowest percentiles of DVP repo transaction rates aren’t necessarily special for speculative reasons, rather reflecting the same problem (collateral scarcity) as softening general collateral rates in BGCR and TGCR, leaving SOFR somewhat higher than its first constituents for theoretical instead of effective reasoning.
Two wrongs don’t make it right; the incomplete estimations aren’t a wash, artificially putting SOFR back up like LIBOR.
On the contrary, we’re introducing only more complexity in ways that heighten uncertainty. We might have to monitor the spread between SOFR and BGCR as another inadvertent stress signal!
Right on “schedule”, the 4-week T-bill rate, perhaps the most reliable and easiest to understand of any indicators, has plummeted consistent with a growing even major collateral strain developing. Not only is this once again well below RRP, it is less than the current RRP even as the next FOMC hike to it is but days away.
This collateral shortfall isn’t exclusive to repo. As I often remind people, the few who get serious enough to question all that wordy dogma, collateral is as much about derivatives, maybe even more these days than straight repo. In the balance sheet constrained environment post-August 2007, there are several fundamental reasons why, say, offering currency swaps would be a far more attractive option.
Those swaps can be structured as synthetic repo, basically leaving yet another huge part of the monetary system out of any official count(s). How huge? We don’t really know, but this week the BIS put out a report which tried to assume a hard number. The best its researchers could do was – and you probably saw this on the internet somewhere, it was all over social media if, as usual, for the wrong reasons – figure $80 trillion.
Not only that, this $80 trillion is mainly…offshore. The amount of unrecognized eurodollars is, well, enough to cause more problems that mere central bank words would never be sufficient to answer for. After all, the BIS tacitly admitted:
“FX swap markets are vulnerable to funding squeezes. This was evident during the Great Financial Crisis (GFC) and again in March 2020 when the Covid-19 pandemic wrought havoc. For all the differences between 2008 and 2020, swaps emerged in both episodes as flash points, with dollar borrowers forced to pay high rates if they could borrow at all.”
What the BIS didn’t say, and never really does, is that as swaps “emerged” as “flash points” that also meant huge collateral demands, too. If a borrower who had borrowed eurodollars in a synthetic repo suddenly finds the costs of rolling it over unaffordable or unavailable, this suddenly panicked borrower might have to scramble to fill the funding gap in straight repo – assuming they could find the right collateral at the same time so many others are likely to be attempting the same.
There is, as always, so much more to say about all of this if only because official central bank words never do or will.
We start with SOFR’s predictable yet potentially damaging foibles, and the short run as well as long run consequences. The nuances behind that $80 trillion, meaning funding problems rather than the more unfounded public fears stoked by ignorant media types shouting about the number rather than what it actually represents. What it actually represents is a monetary system that isn’t just more complicated than we’ve all been taught and told, it is almost completely unlike what we’ve been all taught and told.
This seems rather important, as is why we’re only hearing about it now when, fifteen years ago as the BIS admits, it wasn’t just subprime mortgages, was it?
And, yes, this again points out the futility of bank reserves. Which, once more, is why central banks depend so much on “moral suasion” than anything remotely resembling monetary proficiency. After all, this study finally recognizing the $80 trillion did not come from the Fed, did it?
More immediately, mid-December approaches and even SOFR speaks of growing collateral deficiencies. With monetary shadows so exceptionally huge and mostly unexamined, “vulnerable to funding squeezes” takes on new urgency in the marketplace, accounting for why money curves – starting with the one for LIBOR and eurodollar futures – are so historically inverted at the moment.
Urgency for officials, that’s just a word.
