In the midst of an interest rate transition where trillions of dollars hang in the balance, SEC Commissioner charts a way forward

In remarks to the Financial Stability Oversight Council, SEC Commissioner Gensler applauded the growing adoption by market participants of the Secured Overnight Financing Rate (“SOFR”).

At issue is how the interest rates applicable to trillions of dollars of financial instruments are to be calculated.  Until recently, the London Interbank Offered Rate (“LIBOR”) was widely employed to determine them.

During the past decade, regulatory agencies and some market leaders have advocated for SOFR, despite a desire by some to employ a reference rate based on transactions undertaken in the unsecured credit markets.

As Gensler acknowledged, the terms of such rates have also been an issue of contention.  As parties to a contract hammer it out, they must agree on an interest rate tenor.  This is usually determined by interest rate payment frequency.  If, for example, interest is paid on a monthly basis, a 1-month interest rate is adopted.  If paid quarterly, a three-month tenor would be adopted.  With SOFR, however, there have been issues with crafting a 12-month interest rate, for situations where interest is paid on an annual basis.

In his December 16 speech, Gensler noted that alternatives to SOFR as a replacement interest rate solution theoretically exist.  However, these benchmarks track thin markets with relatively few underlying transactions.  In times of financial stress, these may freeze up, as many did during the global financial crisis of 2008.  This susceptibility to collapse or outside manipulation should act to disqualify such rates as viable candidates for inclusion in financial contracts.

For Gensler, one such possible LIBOR successor, the Bloomberg Short-Term Bank Yield Index (the “BSBY”), “has infirmities that will not stand the test of time”, not meeting “IOSCO’s [International Organization of Securities Commissions] principles for a stable and reliable benchmark.”

In contrast, SOFR, Gensler went on to contend “is not based on the thin, short-term credit markets, I think it is important to continue to ensure that its underlying references of SOFR and the SOFR futures rates Term SOFR references, are truly deeply, liquid and fully clad”.