The Possibility Of The Tail Wagging The DogGuest Post
Truly when the small seems big, and the big seems small, reality may intrude and reverse matters
Today I tweeted:
Fed's Preferred Libor Replacement: SOFR Rate Drop Fuels Jitters Over Transfer https://t.co/oqHADuh2YZ As SOFR gets bigger it could screw up short-term lending markets.
— David Merkel (@AlephBlog) October 21, 2021
What I am about to say is speculative. For the last nine years, I have thought that the move away from LIBOR could be a case of “The cure is worse than the disease.” If you are going to have an index for short-term lending it can be created in a few ways:
- Off of surveys, like LIBOR.
- Off of transactions, like SOFR [Secured Overnight Financing Rate], or the on-the-run Treasury yield
- Off of a liability yield, like a cost of funds index
One of the virtues of a non-transactional benchmark is that you won’t have to deal with the problem where the market generating the index is smaller than the market using the index. When that is the case, you can have those in the market using the index attempting to hedge in the smaller market generating the index, leading to distortions, volatility, etc. Though the small market was created to control the large market, when hedging starts, the large market will dominate the small one, and maybe games will get played in the small market to influence the large market.
As I wrote nine years ago in The Rules, Part XXXII:
Dynamic hedging only has the potential of working on deep markets.
Arbitrage pricing can reveal proper prices in smaller less liquid markets if there are larger, more liquid markets to compare against. The process cannot work in reverse, except by accident.
The SOFR market is a lot smaller than all the floating rate financing that goes on, which is transitioning from LIBOR to SOFR. My fear is that as the conversion from LIBOR to SOFR grows, and SOFR-based new issuance expands, that hedging by taking the opposite side of a SOFR trade will come to dominate that market, leading to volatility, and the taint that comes from the appearance of playing games.
Again, I am not certain here, but I think we may regret the transition from LIBOR to SOFR.
Article by David Merkel, The Aleph Blog