Have the Transfer Pricing Experts at KPMG Heard of the Repo Ruckus?

If one thinks Trump’s economic advisors are the dumbest people on the planet, I have a new candidate for that award – a few supposed experts on intercompany loans that work for KPMG:

In 2017, the ARRC selected the Secured Overnight Financing Rate (SOFR) as the alternative that represents the best replacement rate for USD-denominated LIBOR. SOFR is based on overnight transactions in the U.S. dollar Treasury repo market, the largest rates market at a given maturity in the world ... In the time since the Federal Reserve Bank of New York began daily publication of SOFR in 2018, significant progress has been made in building liquidity in SOFR-linked markets (which include dollar-based derivatives and loans) … SOFR is fundamentally different than LIBOR in a number of key elements. SOFR is (currently) an overnight rate, is secured and is designed to reflect a (virtually) risk-free rate. LIBOR has forward-looking term options, is unsecured and is designed to reflect a bank’s cost of funding. All of these characteristics factor into how SOFR will perform under certain circumstances and how it can be used by market participations. For example, the following figure compares 3-month LIBOR, one the most commonly used LIBOR benchmarks, to the 3-month simple average of SOFR. SOFR is generally both lower and, depending on the methodology applied to derive a term structure, less volatile as compared with LIBOR. This is to be expected given the lower risk profile of SOFR, since it represents borrowings collateralized by U.S. Treasury securities while LIBOR reflects interbank credit risk.

The purpose of their ramblings was to advise multinationals on what to do with a set of their intercompany loans once LIBOR disappears, which is sort of making an easy issue hard so their arrogant and overpriced clowns can charge lots of fees for virtually nothing. But hey – that is what the Big Four does. Any financial economist with half a brain would spot two serious problem with their comparison of SOFR (an overnight rate) with the 3-month LIBOR. Of course the latter tends to be higher than the former as we have been living in a world of an upward sloping term structure for the last decade. There is an overnight LIBOR rate, which closely tracks SOFR for most dates. In fact, the average overnight LIBOR rate over the April 3, 2018 to current period has been a few basis points less. But to claim SOFR has been less volatile? I guess they did not read The Repo Ruckus where Barkley Rosser wrote:

This is now about three weeks old news, but it is increasingly clear that it is not clear why it happened or if it will happen again. There was an outbreak of completely unexpected volatility in the repo market, where in the past the Fed had carried out open market operations, although that had largely passed. Indeed in more recent years when the Fed has intervened in markets it has been in the reverse repo market. In any case, interests rates shot up as high as 9 or 10 percent at one point

Now SOFR only shot up to 5.25 percent. LIBOR showed no such volatility during this period. Now one would think the experts at KPMG would have noticed this market development but it appears they did not. Now who on earth would hire people so utterly clueless? Update: This dumb idea of comparing an overnight rate (SOFR) to the 3-month LIBOR rate may have originated with BDO:

SOFR is a secured interbank overnight interest rate. As a result, SOFR rates are lower than LIBOR rates because SOFR is secured by collateral. The table below shows a comparison between historical LIBOR and SOFR since the introduction of the SOFR in April 2, 2018.

Well not quite. One reason why SOFR is lower than this 3-month LIBOR rate has something to do with the term structure as well. Those who know – avoid BDO!