Case Study: SOFR Swap Funding Strategies - YouTube

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 

9:27 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.