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G. The Interaction between SOFR and the Forward-Looking Term Rate
As noted above, the FSB has been clear in its assessment that financial stability will be enhanced if use
of forward-looking term rates is narrow and most market participants move toward use of RFRs,
while also recognizing the potential usefulness of forward-looking RFR-based term rates as a fallback
rate for legacy contracts and in cash markets in certain circumstances.
While the ARRC has set a goal of seeing a forward-looking term SOFR rate, production of a term rate
can only be guaranteed if most new products use SOFR directly, as otherwise SOFR derivatives
markets are unlikely to achieve or maintain the depth needed to produce a robust term rate. It is also
important that market participants are also clear on what the forward-looking term SOFR rate is
expected to be, and its relationship to the overnight SOFR, in order to understand where use of such
rates could be best made.
While the overnight Treasury repo market underlying SOFR is extraordinarily deep, term repo markets
are much thinner, and it would not be possible to build a robust, IOSCO-compliant rate directly off
the term Treasury repo market. As discussed in the ARRC’s Second Report, there is really no term
cash market in the United States with enough depth to build a reliable, robust, transactions-based rate
produced on a daily basis that would be able to meet the criteria that the ARRC set in choosing SOFR.
Therefore, the ARRC has proposed that a private administrator could construct a forward-looking
term rate based on SOFR derivatives markets once those markets develop enough liquidity. Because
SOFR derivative markets have developed quickly and are expected to achieve a very high degree of
liquidity, it is reasonable to expect that these markets will eventually be sufficiently liquid and robust
to construct a forward-looking term rate, but the timing cannot be guaranteed.
Under the ARRC’s proposal, the forward-looking term rate would be based on some combination of
SOFR futures and SOFR OIS transactions.
14
The ARRC has not endorsed a specific methodology
for producing these rates, but a recent working paper has laid out one potential methodology and the
authors have released a series of “indicative” term rates that may help to promote better understanding
as to how rates of this type might behave over time.
15
As liquidity in SOFR derivatives markets
continues to develop, the ARRC anticipates that private vendors will seek to produce one or more
forward-looking term rates for commercial use, which the ARRC has committed to evaluate with the
aim of recommending one such rate provided that it satisfies the ARRC’s criteria.
Any forward-looking term rates are expected to be equal or close to the underlying SOFR OIS curve.
An OIS contract involves exchanging a set of fixed-rate payments for a set of floating-rate payments
between two parties. The floating rate is a compound average of the overnight rate calculated over
the interest period, while the fixed rate is set at the start of the period. If we call
(
)
the fixed
rate on a 3-month OIS contract entered into at date t, then the 3-month forward-looking term rate
would be either equal to
() or close to it. The same would be true for the potential 1-month
14
These two markets are very tightly linked together. SOFR futures pay an average of SOFR over a given month or quarter,
for example, the average of SOFR realized over the month of June or the average over the first quarter of the year. SOFR
OIS pay the compounded average of SOFR over a fixed period of time, for example, a one-month OIS contract beginning
on March 15 would pay the compound average of SOFR realized over the period from March 15 to April 14.
15
See Heitfield and Park (2019), Inferring Term Rates from SOFR Futures Prices, FEDS discussion paper 2019-014.
Further description of the methodology as well as a data file that presents indicative forward-looking term rates derived
from end-of-day SOFR futures prices and compound averages of daily SOFR rates can be found in Heitfield and Park
(2019),
Indicative Forward-Looking SOFR Term Rates, a staff FEDS Note published April 14, 2019. These rates are
presented for informational purposes only and are not appropriate for use as reference rates in financial contracts.