Passing the Torch from Libor to SOFR
If you are involved in the banking industry or in the CFA® Program, you have probably heard of the London Interbank Offered Rate (Libor). Libor has long been the gold standard benchmark rate in the markets, which is why it is estimated that $200 trillion in US securities are tied to that rate. It has wide usage in contracts and securities including mortgages, floating-rate notes, asset-backed securities, collateralized debt obligations, swaps, options, and other derivatives. It has been a relevant risk-free reference rate for financial transactions for more than 30 years.
As a refresher, it is important to understand how Libor is determined. A panel of major banks are supposed to submit to an oversight authority (currently the UK’s Financial Conduct Authority) actual interest rates they are paying, or would expect to pay for borrowing from other banks. This, in theory, should be a good indicator of the health of the market. However, during the financial crisis, Libor’s credibility took a major hit when it was reported that panel banks colluded to manipulate rates to benefit their positions. Purportedly, the panel banks would intentionally submit lower rates in order to increase profits on large Libor-linked positions.
This revelation led regulators and market participants to question Libor’s future viability. With liquidity concerns due to an ever-decreasing number of unsecured interbank transactions, panel bank submissions are largely based on judgement, which makes these banks less willing to submit and participate on the panel due to litigation concerns. Because of these events and questions regarding Libor’s robustness, the UK Financial Conduct Authority announced that the publication of Libor is not guaranteed beyond 2021.
With Libor cessation imminent, serious questions are being asked—what rate should become the new benchmark? What happens to existing contracts? How can the market ensure rate integrity? It is these types of questions that are currently being tackled through the Alternative Reference Rate Committee (ARRC) and other industry working groups in the United States.
ARRC’s primary mandate was to research and select a new reference rate that was based on real transactions in deeper, more liquid markets than LIBOR. In 2017, the committee selected the secured overnight financing rate (SOFR), which is widely expected to replace U.S. Dollar LIBOR.
What is SOFR?
SOFR measures overnight borrowing in the Treasury repo market. The US repo market is one of the largest markets in the world, making it significantly more liquid with many more market participants than the Libor market. These characteristics make SOFR incredibly transparent and protect it from manipulation. The transactions underlying SOFR regularly exceed $800 billion in daily volumes. Additionally, the overnight market survived the financial crisis, which lends substantial credibility to SOFR and its ability to produce the rate in varying and turbulent market conditions.
Despite these positive features of SOFR, there are important differences to Libor that prevent a completely smooth transition. Three major distinctions that the industry is addressing:
SOFR is a transactions-based rate while Libor requires bank rate submissions and involves increasingly subjective judgement from panel banks.
SOFR is secured and risk free given that underlying transactions are collateralized by Treasuries. Libor, alternatively, is an unsecured bank lending rate that has inherent credit risk.
Given that SOFR is an overnight rate, it is characteristically backward looking and lacks a term structure. Libor, however, has a forward-looking term structure and is quoted in one-day, one-week, one-month, two-month, three-month, six-month, and one-year durations.
While these differences need to be addressed during the transition period leading up to 2021, SOFR’s overnight basis versus Libor’s forward-looking term structure has been a major challenge. For example, many financial contracts have agreed upon rate terms on the closing date referencing one-month or three-month Libor, but this is not a convention with SOFR as there is no term rate. Term repo markets are much thinner, and it is currently not possible to build a robust term rate. This is a major issue in the derivatives market that relies on such term rates. Market leaders are discussing how to augment current conventions to support SOFR.
The ARRC believes that most markets, including fixed income and structured finance, can adapt to this by using compound or simple average calculations over the relevant contract term. For markets that continue to have difficulty in setting standards, the ARRC has continued to investigate ways to produce a forward-looking term rate based on SOFR. However, the best way for this to happen would be for SOFR to develop a more liquid futures market.
Another concern that has been addressed by the Federal Reserve is SOFR’s day-to-day volatility. SOFR jumped at the end of 2018 and again during the overnight credit crunch in mid-September 2019. However, average SOFR has proven to smooth out idiosyncratic volatility as shown:
It is important to keep in mind that the type of SOFR averages that are referenced in recent financial contracts are much smoother than the movements in the overnight rate. The ARRC’s Second Report emphasized this, showing that a three-month average of overnight Treasury repo rates has historically been less volatile than three-month USD Libor over a wide range of market conditions.
What’s Next?
The herculean effort to move the market away from Libor to SOFR has been met with many challenges, but after two years the market is now fine-tuning its transition strategies and addressing the robustness of current and future securities contracts. The amendment of existing contracts requires identification of affected securities, legal review, and transition costs between issuers, investors, trustees, and other involved parties. This may be the most time-consuming step as multiple parties with varying interests are required to agree to new terms. However, this will promote financial stability ensuring contracts have references to SOFR and appropriate rate fallback language when Libor is discontinued.
With 2021 fast approaching, industry working groups will also continue to tackle challenging topics such as infrastructure, tax and accounting, valuation, and regulation:
Issues related to trade data, clearing system enhancements, and operational payment systems need to be upgraded to accept alternative rates and calculations.
Taxation as it relates to mid-contract rate changes may create payment and withholding considerations.
Fair value estimates, hedging strategies, and accounting may become more complicated as contrasting rate structures will require modification of complex financial models.
Regulation and risk controls will need to be modified to account for the differences in rates.
Market participants have been working diligently on the multifaceted transition to make the market more transparent and secure. Despite the questions that remain, the financial world will be ready if and when Libor is discontinued. This will not be a Y2K-like scare as the date approaches. Term SOFR rates, most likely to align operationally with Libor, seem subordinate in priority to existing tasks at the moment. Time will tell if derivative markets can catch up to provide a strong alternative.
About the Author
Andrew Gallagher, CFA, is a product manager for Citi Agency and Trust, which manages $6 trillion in trust assets globally. He works with corporations and financial institutions to address their fiduciary, fiscal, and agency needs for debt issuances and money market programs. Prior to this role, he worked in various positions including financial planning and analysis, business management, and market strategy. Andrew received his MBA from NYU’s Stern School of Business. He is a graduate of Columbia University, where he received a BA in economics.