Navigating the Shift: Understanding the Implications of Moving from LIBOR to SOFR

Why is LIBOR Abandoned?

For more than 40 years, the London Interbank Offered Rate is commonly known as LIBOR was a key benchmark for setting the interest rates charged on adjustable-rate loans, mortgages, and corporate debt.

Over the last decade, Libor has been burdened by scandals and crises. Effective January 2022, Libor will no longer be used to issue new loans. It is being replaced by the Secured Overnight Financing Rate (SOFR), which many experts consider a more accurate and secure pricing benchmark.

How is LIBOR calculated?

It was set daily by collecting estimates from up to 18 global banks on the interest rates they would charge for different loan maturities, given their outlook on local economic conditions. Libor was calculated in five currencies: the UK Pound Sterling, the Swiss Franc, the Euro, the Japanese Yen, and the U.S. Dollar.

Where is LIBOR applied?

It’s used to price adjustable-rate mortgages, asset-backed securities,?government bonds, credit default swaps, private student loans, and other types of debt. FI applies the loan rate as LIBOR + margin considering credit score, income, and the loan term.

LIBOR Scandals & Impacts

The use and abuse of credit default swaps (CDS) was one of the major drivers of the 2008 financial crisis.?American International Group (AIG) was the biggest player in the CDS disaster. Rates for CDS were set using Libor, and these derivative investments were used to insure against defaults on subprime mortgages. The crash of the real estate market in 2007, followed by the even larger market meltdown in 2008, forced AIG into bankruptcy, resulting in one of the largest government bailouts in history.

During the LIBOR Scandal, traders at many of these banks deliberately submitted artificially low or high interest rates to force the LIBOR higher or lower, to support their own institutions' derivative and trading activities. The LIBOR scandal was significant because of the central role LIBOR plays in global finance. Understandably, this led to a substantial public backlash. Regulators?in both the United States and the United Kingdom levied some $9 billion in fines on banks involved in the scandal, as well as a slew of criminal charges. Affected corporates filed lawsuits, alleging that the rate-fixing negatively affected them. Similarly, many traders who were party to derivative contracts would have experienced unnecessarily severe losses as a result of the LIBOR scandal.

Replacement of LIBRO – Introduction of SOFR

The global financial system decided to stop relying on the tarnished interest-rate benchmark which underpinned trillions of dollars in contracts across the globe. Starting in 2022, new deals were not supposed to be linked to LIBOR.

The New York Federal Reserve launched a possible LIBOR replacement in April 2018 called the?Secured Overnight Financing Rate?(SOFR), which is based on short-term loans observed in the repo market. Unlike the LIBOR, there’s extensive trading in Treasury?repos, theoretically making it a more accurate indicator of borrowing costs. Moreover, the SOFR is based on data from observable transactions rather than on estimated borrowing rates, as is sometimes the case with LIBOR. SOFR represents the cost of borrowing for a broader variety of market participants and is based on actual transactions in overnight lending markets.

If you need more information about SOFR, please visit the below website: https://www.sofrrate.com/

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