Goodbye LIBOR, Hello SOFR!

In the world of finance, there is one number that arguably matters more than any other and it is on the way out. Libor, or the London Inter-bank Offered Rate, is the rate that banks charge each other for short-term loans —  it’s used as a benchmark for other debt instruments such as government bonds, corporate loans, etc. Libor presently serves as the benchmark rate for over US$200 trillion of US dollar-based derivatives and loans.

The death warrant of Libor

As unsecured lending declined after the 2008 global financial crisis, Libor was less referenced. Four years later came a rate-rigging scandal, and suddenly world’s most important number used for pricing risk and a host of financial instruments — loans, derivatives, and mortgages — no longer commanded the confidence of financial markets.

Unlike a stock price, which is based on a public record of buys and sells, the Libor rate is something banks report based on their own proprietary observations, making it open to manipulation. In 2012, financial industry regulators discovered manipulation of the rate-setting process that underlies Libor. The Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARCC) in 2014 in order to, among other things, identify the best practices for establishing an alternative reference rate in replacement of Libor.

Successor of Libor

Some benchmark rates are already emerging to take its place. Financial institutions use benchmarks to set their own rates, and the usefulness of each benchmark rate derives in part from how accurately it tracks debt-market risk. As new benchmarks haven’t yet built up a long-term track record, transactions based on alternative benchmarks have so far been mostly short-term instruments. The alternative benchmarks include Saron (Swiss Average Rate Overnight) for Swiss francs, Sonia (Sterling Overnight Index Average) for pounds sterling and Tonar (Tokyo Overnight Average Rate) for yen. Each is promulgated by a different authority with slightly different features in tenor, liquidity/market depth, credit risk, and bad-actor risk.

Major markets across the banking and financial industry are looking to transition (some) liquidity away from Libor-based products and towards risk-free rates. Ultimately the market will decide the successor of Libor.

New benchmark rate: SOFR for USD

At the start of 2019, the Fed is expected to circulate letters checking US banks’ readiness for a new benchmark rate. The New York Fed, in cooperation with the Office of Financial Research, has announced its intention to produce three reference rates based on trade-level data from various segments of the repo market:

  • TGCR – Tri-party General Collateral Rate: Based on trade-level tri-party data
  • BGCR – Broad General Collateral Rate: TGCR + GCF repo
  • SOFR – Secured Overnight Financing Rate: BGCR + FICC-cleared bilateral repo.

On 22 June 2017, the ARRC identified the SOFR as its preferred alternative to USD Libor. SOFR is an overnight collateralised rate based on daily repo transactions, typically over US$700 billion each day. It is calculated using actual transactions in repurchase agreements (repo) versus US Treasuries. It encompasses a robust underlying market. This overnight rate is a nearly risk-free rate that closely correlates with other money market rates. According to the New York Fed, it covers multiple repo market segments allowing for future market evolution. SOFR has been officially published since early April 2018.

Many of the changes required to begin using SOFR are already in progress. This includes CME Group supporting SOFR futures trading and swaps clearing, as well as the Financial Accounting Standards Board (FASB) proposing the eligibility of SOFR as a permissible US benchmark interest rate for hedge accounting. The CME Group launched new SOFR futures contracts on 7 May 2018. On day one of trading, more than 50 entities traded about 3,000 one-month and three-month SOFR futures.

The SOFR market has developed substantially faster than many anticipated, given that the new rate was first published in April by the New York Fed. The World Bank (International Bank for Reconstruction and Development, IBRD) priced its first Secured Overnight Financing Rate (SOFR) bond on 14 August 2018. The 2-year USD-denominated benchmark bond raised US$1 billion from investors in the Americas and Europe. The bond has a coupon of SOFR + 22bps, reset daily and paid quarterly with a 4-day lockout and a maturity date of 21 August 2020. This latest World Bank bond transaction responds to investor demand for high-quality assets and helps develop the market for SOFR – a rate based on transactions in the U.S. Treasury repurchase market and an alternative reference rate to USD Libor.

New benchmark rate: Ester for Euro

Before October 2019, the European Central Bank is expected to publish a new overnight reference rate for the euro interbank market called Ester (Euro Short-Term Rate). ESTER reflects the wholesale EUR unsecured overnight borrowing costs of Euro area banks. It is based on borrowing transactions in EUR conducted with financial counterparties and is calculated using overnight unsecured fixed rate deposit transactions over EUR 1 million. It will complement existing benchmark rates, like EONIA, produced by the private sector and will serve as a backstop reference rate.

Unlike Libor, which was self-selected and regulated by a panel of banks, these new benchmarks will be overseen by central banks.

Transition to new benchmark rates will be an arduous process

The financial industry is trying to create a realistic alternative to Libor, but it will be challenging to switch seamlessly over to a newly created index by 2021.

Stories of Libor’s demise may be somewhat premature, however; a benchmark that has underpinned pricing, valuations and risk modeling in financial markets for more than three decades is unlikely to disappear overnight. There are some concerns regarding the transactions and the new reference rate:

  • Credit agreements for syndicated loans have traditionally contained “Libor fallback” language that specifies what happens in the event Libor becomes temporarily unavailable. Switching them over to the new benchmarks will take time. Banks will need to determine which contracts have fallback language, how they are automatically repriced and how that is communicated to the customer.
  • The repo market is less liquid and more volatile than the Libor market, how will this be an improvement? The repo market needs some smoothening.
  • SOFR, because it is collateralised by the U.S. Treasuries, is meant to reflect a risk-free rate. Libor, meanwhile, is meant to reflect a bank’s unsecured cost of funds.  Therefore, there should be a spread between these two indices to reflect the creditworthiness of the banking industry, but it remains to be seen what that spread looks like.
  • Libor is quoted across seven tenors ranging from one day to one year (with one-month and three-month Libor being the most often used tenors in the loan market). By contrast, SOFR is a spot rate – it is calculated by taking the average of certain Treasury repo transactions that were entered into on a preceding day.  Accordingly, a SOFR “term curve” will need to develop in the market in order to provide forward-looking one-month and three-month SOFR quotations.

Some market participants believe it will take longer than 2021 for Libor to go away. Transitioning away from Libor will likely be an arduous process, even under the best of circumstances. While financial markets are in the process of phasing out Libor, the publisher of Libor (ICE Benchmark Administration or IBA, in short) recently announced that it is taking steps to make Libor a more “robust and sustainable benchmark.” With the uncertainty of Libor’s future and the future of the SOFR, participants worldwide are waiting for further developments before making any decision.

Hold on. We may be in for a bumpy ride away from Libor.