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 USD 200 trillion of US dollar-based derivatives and loans. 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.
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.
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. Transitioning away from LIBOR is likely to be a complex and multi-year process. The New York Fed, in cooperation with the Office of Financial Research, has announced its intention to produce three reference rates based upon 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 USD 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 correlate with other money market rates. According to New York Fed, it covers multiple repo market segments allowing for future market evolution. SOFR has been officially published since early April 2018.
SOFR is an overnight funding rate that resets every day, whereas Libor measures a bank’s cost of borrowing cash over different periods (one month, three months, six months, etc). Although SOFR addresses many of the liquidity and manipulation vulnerabilities of LIBOR, each benchmark measures different degrees of risk, and SOFR reflects a spot market while LIBOR reflects a term market.
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 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 USD 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.
There are, however, some concerns for 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. How will lenders account for loans and derivative contracts that extend beyond 2021?
- 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 credit worthiness 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 the 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. In May 2018, the CME Group began offering futures trading for one-month and three-month SOFR futures.
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.