SOFR: Conduct risk considerations for Lockout conventions

The transition from Inter-Bank Offered Rates (IBORs) to Alternative Reference Rates (ARRs) presents several key conduct risk considerations; some are well known, and others are continuing to emerge. A particular case meriting attention is the use of lockout conventions in products referencing the Secured Overnight Financing Rate (SOFR) – the ARR replacing LIBOR for US dollar-denominated products.

Market participants will be well aware of SOFR’s tendency to spike at month-end, sometimes as much as 60 basis points, owing to supply and demand dynamics of treasuries and dealers’ asset-liability management. Spikes of this scale will invariably have an upward impact on averaged interest rates – unless they are effectively excluded from calculations.

While settlement conventions are still maturing, one way in which spikes can be excluded is through lockout conventions, to which the US market is converging. These are widely used in products that reference interest rates (such as SOFR ) as a mechanism to provide a degree of cash flow certainty before an interest payment is due. Lockout conventions achieve this by repeating one of the daily rates for the final few days of the calculation – often at month end.

Use of lockout provisions therefore implies conduct risk where banking clients and counterparties can effectively be prevented from benefiting from the monthly SOFR spikes that would increase their average interest rates over the period. The Alternative Reference Rates Committee highlighted this risk in respect of bonds: “A lockout period at the end of each interest period means that a meaningful number of days in the life of the bond are being excluded from the interest calculation and this could be material to the extent that SOFR is volatile” . To date, 31 institutions have issued $236 billion notional in floating rate instruments tied to SOFR, including a record $55.7 billion in August 2019.

As conventions continue to mature, careful consideration should be applied when using lockout conventions to ensure clients are being treated fairly and appropriately. Such considerations should feature prominently at new product approval governance forums and formal suitability and appropriateness reviews. Firms should also be covering this topic transparently with clients and counterparties on contracting, to ensure they are appropriately informed according to their level of sophistication.

For further technical insight on SOFR spikes please see our paper Conditional Heteroscedasticity and Jumps in SOFR Time Series