Will the New LIBOR Replacement Please Stand Up: Introducing SOFR, The Fed’s Recommended Alternative

The London Interbank Offered Rate (LIBOR) began when banks realized they needed a consistent benchmark to reflect the cost to borrow on an unsecured basis in “wholesale” markets, for bank-to-bank services. Today LIBOR is the most widely used interest rate benchmark in the world and determines the interest rate on a range of financial instruments including mortgages, student loans, government loans, and currency swaps, among others. LIBOR is calculated and published daily across five currencies and seven maturities. There is an estimated $350 trillion of financial contracts tied to LIBOR globally and U.S. dollar (USD) LIBOR is used as a reference rate for more than $200 trillion of financial contracts in the cash and derivatives market.

Why Replace LIBOR?

There is a lack of confidence in current LIBOR calculations due to manipulation scandals. LIBOR is an average of rates posted by banks and is not necessarily transaction based. It is the rate at which banks offer money whether there are takers or not. Instead of posting solely on transactions, it became obvious during the financial crisis that banks could manipulate the data when bank credit spreads gapped out, but LIBOR did not. The result of regulators’ investigations led to the discovery that banks had been manipulating LIBOR since at least 1991 in order to earn as little as an extra basis point which could net millions of dollars on a trade. This is the reason why the Federal Reserve Board and other international governing bodies have proposed potential rate substitutes to replace LIBOR. Alternative rates are needed which are less reliant on subjective calculations and behave differently from existing LIBOR rates. Due to the impact on financial institutions and the potential for disruptions to business operations, this alternative rate will require appropriate adjustments to guarantee a seamless transition.

This transition is needed to maintain a sound and resilient financial system. The UK’s Financial Conduct Authority (FCA) is responsible for regulating LIBOR. The FCA Chief Executive Andrew Bailey has made it clear that the publication of LIBOR is not guaranteed beyond 2021. This possibility that the production and availability of LIBOR might cease permanently is important because the potential disruption poses a financial stability risk. 

Since February of 2014, the ICE Benchmark Administration (IBA), an American company that owns and operates electronic exchanges for financial and commodity markets, replaced the British Bankers Association as the LIBOR administrator. ICE collects and posts the LIBOR data currently. The Fed, FCA and other regulators have recommended eliminating LIBOR as far back as 2012, creating the possibility that LIBOR may cease to exist if ICE stops collecting and reporting it.

There is a sense of urgency that LIBOR has the potential to end after 2021. There is work being done to prepare for a smooth transition and identify exposures and highlight key challenges involved in transitioning to a new reference rate. The goal is to do it in a manner that protects the liquidity and resiliency of both cash and derivatives markets.
 

Introducing SOFR

In 2014, the Federal Reserve Board designated the Alternative Reference Rates Committee (ARRC) as the responsible body tasked with identifying an alternative rate for the U.S. dollar LIBOR.

In 2017, the ARRC identified the Secured Overnight Financing Rate (SOFR) as the rate that represents best practice for use in certain new USD derivatives and other financial contracts. It is produced and published each business day by the New York Fed in cooperation with the Office of Financial Research. SOFR is a broad measure of the cost of borrowing cash based on overnight transactions collateralized by U.S. Treasury securities in the repurchase agreement (repo) market. The repo market is the largest rates market in the world for a given maturity and provides important transactional and liquidity measures.
 

Is SOFR Perfect?

The main goal of a potential rate substitute to replace LIBOR is choosing one that would not be manipulated in the same way traders manipulated LIBOR. Given that the SOFR data submitted to the FED will be transaction based, it makes it extraordinarily difficult to manipulate. It will be derived from an active and well-defined market and the transaction volumes underlying SOFR are far larger than the volumes underlying LIBOR.

The main drawback relative to LIBOR is that SOFR is a fully collateralized rate, which means it will most likely not rise alongside bank funding costs due to credit or liquidity concerns. Not rising alongside bank funding costs means the rate will not provide a natural hedge against unsecured funding costs.  Although, the LIBOR investigation was initiated because LIBOR did not always widen when bank credit spreads rose.

SOFR is derived from a market that was able to weather the global financial crisis and covers multiple repo market segments allowing for future market evolution. The ARRC has noted that it believes SOFR will remain active enough in order that it can reliably be produced in a wide range of market conditions.
 

Where Are We Now?

To support the transition to SOFR, the ARRC developed the Paced Transition Plan. This plan was developed with specific steps and timelines designed to encourage adoption of SOFR and outlines the key milestones until the end of 2021.

The ARRC also issued a set of 2019 Incremental Objectives, which complement the Paced Transition Plan by outlining key priorities to support the usage of SOFR-based financial products with the goal of developing sufficient liquidity and prepare market participants for the transition.

The ARRC is also working to address the fact that many contracts for products referencing USD LIBOR do not adequately account for the possibility that LIBOR may no longer be usable. The ARRC has released final recommended language on USD LIBOR fallback contract language for market participants’ voluntary use in new contracts that reference LIBOR with the goal to protect against the risk of serious market disruptions.

Source: Federal Reserve Bank of New York (SOFR: A Year in Review)
https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2019/SOFR_Anniversary.pdf

Bottom Line

It is too soon to tell if SOFR will be adopted for general use as a replacement for LIBOR. Regulators would like LIBOR replaced due to how easy they believe it is to manipulate. The future of LIBOR beyond 2021 is uncertain. The NY Fed has endorsed SOFR which gives it real support to be adopted and to meet the needs for general use. One of the immediate issues is that a term market for SOFR does not exist yet. CME group, a U.S. based global markets company, and ICE began supporting 1-month and 3-month SOFR futures in 2018. Trading activity in SOFR-linked futures continues to increase, creating a baseline level of liquidity for derivatives contracts referencing SOFR. The final step in the Paced Transition Plan is the creation of a forward-looking term structure for SOFR. However, the Fed has noted that while liquidity has improved, it is still not sufficient to create a robust, forward-looking term rate. If financial institutions do switch from LIBOR to SOFR, hopefully this means that the appropriate adjustments to guarantee a seamless transaction to this new benchmark rate have been made and they are prepared to move to a more reliable and resilient financial system.

Sources:

http://en.finance.sia-partners.com/20181015/rip-libor-how-prepare-sofr

https://www.sifma.org/resources/news/be-prepared-be-resilient-be-consistent-preparing-for-a-day-we-may-be-without-a-libor-reference/

https://www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-Sept-20-2018-FAQ.pdf

https://www.newyorkfed.org/arrc/about

https://www.newyorkfed.org/arrc/sofr-transition

https://www.cmegroup.com/trading/interest-rates/secured-overnight-financing-rate-futures.html

Low, Chris, “Introducing SOFR, The NY Fed’s Recommended LIBOR Replacement”, ECONOMIC WEEKLY, April 6, 2018, FTN Financial.

https://www.moneycrashers.com/libor-rate-history/

https://www.federalreserve.gov/econres/notes/feds-notes/indicative-forward-looking-sofr-term-rates-20190419.htmWhite Papers