​Case Study: SOFR Swap Funding Strategies


Case Study: SOFR Swap Funding Strategies
Hello, everyone, my name is Andrew Paolillo and I'm the Director of Member Strategies and Solutions here at the Bank. Thank you for joining us for our newest case study, SOFR Swap Funding Strategies.
So, what we'd like to do today is take a look at a popular strategy that many members use, where using an interest rate, swap paired with rolling short-term advances, and how that strategy will evolve as the market transitions away from using LIBOR as the predominant index, and … begins to use other indices. So, as we look at how this strategy will change over time, we can see that we can accomplish a number of intended goals and that being the potential to save on interest expense, something that is important for many, but also support the liquidity profile. Certainly, maintain hedge effectiveness and make sure everything is as is on that front. And, as we mentioned earlier, begin to transition away from any further LIBOR exposure as the sunset of that index continues.
So, first, let's take a look and how this cash flow hedge strategy has worked traditionally. So, in the world of LIBOR derivatives, the first step in the strategy was to pay the fixed rate on an interest-rate swap
And at the same time, receive the floating rate index. So, in this case it would be one-month LIBOR.
Then the second component of this would be to pay the short-term funding rate and roll that continually for the life of the swap.
So, let's look at a specific example here.
​So, in a case where a member was looking to capture five-year funding, the LIBOR swap strategy would involve paying the fixed swap rate or in this case, 75 basis points.
For the first month, they would receive one-month LIBOR on that particular date at 11 basis points.
For the funding of the trade, they would pay the going rate on the Classic Advance of 35 basis points.
So, when you add that all up, the initial all-in rate was 99 basis points.
And we compare that to the five-year Classic Advance at a rate of 1.06, which would incorporate taking advantage of the Advance Renewal Discount Program.
So, what we're left with is two instances where the member can achieve five years’ worth of term rate protection, but the difference in the two strategies is in the liquidity protection. Where [with] the Classic Advance, the liquidity profile aligns with that of the interest-rate exposure, five years, the swap strategy is a little bit different in that you get the term rate protection, but the liquidity protection, because the funding is only at the one-month mark needs to be continually ruled month after month.
So while the LIBOR transition has been many years in the making, and a lot of financial institutions of all shapes and sizes have put resources into this, there have been three notable events that occurred in the last couple of months that are worth pointing out.
So, the first thing occurred in October of 2020 where there was a change in the discounting methodology for LIBOR-based derivatives, going from using effective Fed Funds to SOFR.
So, what that caused was that a lot of institutions who previously may not have had SOFR exposure, now have. So, that has created to greater activity and volume and adoption in the SOFR derivatives market and added liquidity there.
The second thing that happened was in November there was a joint statement from the U.S.
banking regulators explicitly encouraging institutions to cease using LIBOR, ideally as soon as practical but, certainly, in any event before the end of 2021. So that is the most direct they've been thus far, in terms of what the expectations are for using LIBOR going forward.
The last thing to point out was in, just recently this month, they confirmed the dates when certain tenors of LIBOR will explicitly cease to be published. So, it varies depending on which version of LIBOR that you're talking about.
And they did extend the most applicable for our members: one- and three-month LIBOR will continue to be published out to June of 2023.
But, again, this has increased the transparency and the expectations for what institutions are going to have to do in terms of both legacy LIBOR exposure, but also new instruments going forward.
So, with the market gravitating away from LIBOR,
how does this cash flow hedge strategy
look in a world where LIBOR derivatives aren't going to be used?
So, remember, this visual from a couple of slides ago where we have the two steps involved in affecting the strategy, where the first one is executing the swap, where you're paying a fixed rate, and you're receiving a floating rate. So, the same thing that has happened, historically.
And on the funding side,
the same thing is going to happen again. 
You're going to continue to pay or roll the short-term funding rate.
Now, where the mechanics begin to differ, it ties back to the difference in the index being used. So, if we recall from the LIBOR
example, the index was a forward-looking term rate, so, in that case, a one-month index.
So, the funding solution was a one-month bullet Classic Advance against it. SOFR, as well as Fed Funds, are both overnight indices. So that creates a difference and an added layer of involvement versus what goes on with LIBOR. So, let's walk through the SOFR swap example.
So, in this case again using five years we would pay the fixed rate on a swap of 64 basis points.
And we would receive the floating-rate index of four basis points.
And, to fund it, we would pay the short-term funding rate of 27 basis points. And now, where did that, 27 basis points come from?
That comes from using a 12-month SOFR-Indexed Advance priced at a spread of plus 23.
So, you have the index rate of four basis points plus the spread on the advance of 23, gets you to the all-in of 27.
And when we look at what that creates for the all-in funding rate, it comes out to 87 basis point.
Now, we compare that versus the LIBOR swap example, as well as the Classic Advance, and we can see that it is the cheaper alternative.
And we see that identical term rate protection of locking in the rate for five years. And we'll look at a visual on the next slide where the difference and the appeal of this strategy is that the term liquidity protection, where we know in the Classic Advance we get the full five years, but in the LIBOR swap, we only get the one month of the funding.
Well, because of the floatin -rate nature of the advance, the funding, you're able to capture greater amounts of liquidity protection while still getting the alignment of the index and meeting the hedge effectiveness.
So, like we just said, here's the visual showing the benefits and the mix of the two key features.
So, when you're looking at long-erm funding, you have the term rate protection and the term liquidity protection.
So, we can see here, this example of using the SOFR swap compares favorably on a price or cost perspective versus the LIBOR swap strategy, as well as the Classic Advance strategy.
And on the term liquidity protection it doesn't provide the full five years’ worth of liquidity protection, that the bullet advance does.
But it certainly provides more than the rolling one-month strategy that comes from the LIBOR swap. So, that may have value to institutions looking to kill two birds with one stone. They want to get the term rate protection that that fits in to the overall ALM
profile, but the added liquidity has value as well
and certainly, it has value if it comes at a price that is actually less than the alternative.
So, as the market evolves and these strategies transition to this post LIBOR world, there are a couple of things to point out that do create some interesting opportunities.
So, the first one would be the ability to tailor or customize the maturity of the funding.
So, when you think back to the, the LIBOR swap example, there really isn't any wiggle room.
If it was a swap versus one-month LIBOR, then the funding had to be of a maturity of one month, end of story.
But when you think about this new strategy where the index is an overnight rate on both the swap and on the advance, in some regards the maturity, it doesn't matter.
So, you may be getting the longer-term rate protection that you want, but you want a little bit more liquidity protection
whether, from a liquidity management perspective, or even an operational or logistical perspective, where rolling the funding 11 times in a year, isn't ideal.
So, if you were inclined to fund at one month, or six months or 12 months, that may have some appeal
from both the operational and the liquidity perspective,
​and you're still going to get the alignment of the index rates that you need to get in order to make the strategy work.
The second thing worth pointing out is that aside from SOFR, there is a robust market in
OIS Fed Funds derivatives. And the historical correlation between Fed Funds and SOFR is extremely strong such that the SOFR-Indexed Advance can be a useful funding tool not just for SOFR
swaps but also OIS Fed Fund swaps.
So, if that is -- and we've certainly seen and heard that from members who have begun to transition and started to use 
OIS Fed Fund instruments as well -- that because of that extremely tight correlation, historically, then that can be a useful funding vehicle.
The last thing that I'll point out is talk to all your advisors, and we talk to all of them as well.
So, the dealers, the advisors, and the accountants, on understanding what you can do and what flexibility that you can put into the contracts, to make sure that you're doing all the things
to make sure that, not just you meet the requirements of the swap agreement, but also that you're designing the funding that meets
the needs for optimizing your liquidity levels, as well as minimizing interest expense.
So, that's all we have for our case study here today. If you have any questions, please feel free to reach out to me directly or to your relationship manager
and we would be happy to go into greater detail about some of the work that we've put together surrounding this topic, and even relate some of the conversations that we've had with the aforementioned other market participants, and give you some insight as to what we're seeing and hearing out there. Thank you very much and have a great day.


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​Presentation Slides

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