In remarks made to the SEC Fixed Income Market Structure Advisory Committee on November 4, 2019, SEC Chair Jay Clayton raised concerns for both the structured and rate notes communities.1

Chair Clayton questioned whether investors and their advisers understood how indices are constructed from a technical perspective (e.g., weightings and adjustments), the opportunities and risks of an investment referencing the index and the types of key value adjustments that the index administrator may make, such as what types of companies are included in the index. Chair Clayton also asked whether more disclosure should be encouraged or required. Chair Clayton echoed these remarks three days later in a speech to the SEC Investor Advisory Committee.2

On rates, Chair Clayton lauded current efforts to replace LIBOR and referred to the secured overnight financing rate ("SOFR") as a "potential replacement." He also voiced his concern that "more work needs to be done for the transition to avoid substantial frictions, including frictions that will harm investors directly, through higher costs, and as a result of uncertainty more generally." Chair Clayton gave a simplified explanation of his concerns, noting that current LIBOR securities reflect three components: a risk free rate, a bank funding/base lending spread over the risk free rate and an additional fixed spread to/from the lender/borrower or customer. The last would be the typical spread added to a LIBOR floating rate note. Current 3-month USD LIBOR incorporates the risk free rate and the spread over the risk free rate.

In contrast, SOFR is just a risk free rate, but does not reflect the fluctuating bank funding spread over the risk free rate. A SOFR product, such as a SOFR floating rate note, would incorporate the SOFR rate and a fixed spread, but would not fully incorporate the floating bank funding spread.

In Chair Clayton's view, this would "make a like-for-like mapping of a LIBOR product to a SOFR product challenging." Chair Clayton's skepticism of SOFR as a replacement for LIBOR continues a theme expressed by the SEC in July 2019, when the SEC Staff stated that it did not endorse the use of any particular reference rate as a LIBOR replacement.3

Originally published in REVERSEinquiries: Volume 2, Issue 11.
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Footnotes

1 Chair Clayton's speech is available at: http://bit.ly/2sGsgzD.

2 Chair Clayton's speech to the Investor Advisory Committee is available at: http://bit.ly/2Pc7waI.

3 We discussed the July 2019 SEC Staff Statement on LIBOR Transition in Volume 02, Issue 07 of REVERSEinquiries, available at: http://bit.ly/34REqE5. The Staff Statement is available at: http://bit.ly/2rWRI3u.

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