Transition from LIBOR to SOFR

The transition from LIBOR (London Interbank Offered Rate) to SOFR (Secured Overnight Financing Rate) is a significant event in the financial world. LIBOR has been a key benchmark for various financial products globally, but concerns about its reliability and susceptibility to manipulation have led to a global effort to replace it with alternative reference rates such as SOFR.

For over 04 decades, the London Interbank Offered Rate (LIBOR), served as a crucial benchmark for determining interest rates on various financial products such as adjustable-rate loans, mortgages, and corporate debt. However, in recent years, LIBOR has faced challenges due to scandals and crises.

As of January 2022, LIBOR is no longer utilized for originating new loans in the United States, with the Secured Overnight Financing Rate (SOFR) taking its place as the preferred benchmark. SOFR is viewed by many professionals as a more precise and secure pricing reference compared to LIBOR.

What is LIBOR?

The LIBOR rates were calculated in five currencies: UK Pound Sterling, Swiss Franc, Euro, Japanese Yen, and US Dollar. Estimates from 18 global banks on interest rates for various loan maturities were collected daily to determine LIBOR. Financial firms would add an extra percentage to the LIBOR rate when applying it to a loan. The published LIBOR rates include overnight, 1-month, 3-month, 6-month, and 12-month maturities.

Every day, 18 international banks provide their estimated borrowing rates to the Interbank lending market in London. The ICE (Intercontinental Exchange) Benchmark Administration removes the four highest and four lowest submissions to prevent extreme fluctuations in the average rate calculation. LIBOR is not determined by actual borrowing rates, but by banks' estimations of what they would pay. This system allows banks to potentially manipulate LIBOR by submitting lower rates. Several banks, such as Barclays, Deutsche Bank, Rabobank, UBS, and the Royal Bank of Scotland, have been found guilty of manipulating LIBOR for financial gain. Lower LIBOR rates are seen as an indication of lower default risk, suggesting a bank's financial stability compared to others with higher rates.

This led to concerns about the accuracy and reliability of LIBOR. Additionally, regulatory bodies expressed concerns about the lack of underlying transactions in the interbank market that LIBOR was supposed to represent. Hence, the need for a more robust alternative arose, leading to the development of SOFR.

LIBOR to SOFR

SOFR is based on transactions in the U.S. Treasury repurchase market, which is considered to be deeper and more liquid compared to the interbank lending market. It reflects the cost of borrowing cash overnight collateralized by U.S. Treasury securities. SOFR is therefore considered to be a more reliable and transparent benchmark.

In the United States, SOFR has emerged as the primary alternative to LIBOR. All contracts that reference LIBOR should be concluded by June 30, 2023.

The transition from LIBOR to SOFR has been underway for several years. Various regulatory bodies and industry groups have been urging market participants to transition their contracts and financial products to alternative rates like SOFR. Different jurisdictions may have different timelines for the transition. The discontinuation of LIBOR gives rise to two main challenges: selecting a replacement rate and renegotiating existing contracts tied to LIBOR.

Transitioning from LIBOR to SOFR often requires amending contracts, particularly for derivatives, loans, bonds, and other financial instruments that reference LIBOR. New contracts are being issued with reference to SOFR, and existing contracts are being amended to include fallback provisions or transition to alternative rates.

Market participants, including banks, corporations, asset managers, and investors, have been gradually adopting SOFR-based products and transitioning away from LIBOR-based products. This adoption process involves changes in systems, processes, and risk management practices to accommodate the new reference rate.

SOFR (Secured Overnight Financing Rate)

SOFR serves as a benchmark interest rate for dollar-denominated derivatives and loans, taking over from LIBOR. It reflects the cost of borrowing cash overnight collateralized by U.S. Treasury securities in the repurchase market. SOFR is derived from transaction-level data overseen by the Federal Reserve and obtained from the Depository Trust & Clearing Corporation. Widely regarded as the most liquid financial market globally, SOFR is highly influential. The New York Fed releases the SOFR daily on its website around 8:00 a.m. ET.

Genres of SOFR

• Daily Simple SOFR? Calculated using simple interest over the current interest period. For Daily Simple SOFR, the overnight SOFR rate is obtained daily and multiplied by the outstanding principal of the loan
• Daily Compounded SOFR? Uses the overnight SOFR rate, which is then compounded daily during the interest period to determine the loan's interest rate
• Term SOFR? Calculated differently than the other types of SOFR. It is not possible to calculate Term SOFR from the term treasury repurchase market. It is produced from the SOFR derivatives markets.

Advantageous of SOFR

1. Risk-Free Rate: SOFR is based on transactions in the overnight U.S. Treasury repurchase agreement (repo) market, which is considered a deep and liquid market. Unlike LIBOR, which includes a credit risk premium, SOFR is essentially a risk-free rate, making it more resilient during times of financial stress.
2. Transparency and Objectivity: SOFR is based on actual transactions rather than banks' estimates, which increases transparency and reduces the risk of manipulation. This enhances the integrity and reliability of the benchmark rate, contributing to greater market confidence.
3. Robustness and Representativeness: SOFR is based on a large volume of transactions in the repo market, reflecting actual borrowing costs for a wide range of market participants. This makes SOFR more robust and representative of market conditions, reducing the risk of distortion or manipulation.
4. Alignment with Global Standards: As part of the global transition away from LIBOR, many jurisdictions are adopting risk-free rates (RFRs) similar to SOFR. This alignment promotes consistency and compatibility across different markets, facilitating cross-border transactions and reducing complexity for market participants.
5. Reduced Basis Risk: Basis risk arises when there are discrepancies between the reference rate and the actual funding costs or cash flows of financial instruments. SOFR, being a more accurate reflection of overnight borrowing costs, helps to reduce basis risk compared to LIBOR, leading to more effective risk management for market participants.
6. Standardization and Efficiency: The transition to SOFR promotes the standardization of financial contracts and products, which improves market efficiency and liquidity. Standardized contracts referencing SOFR facilitate price discovery, reduce operational complexity, and enhance market liquidity.
7. Regulatory Support and Guidance: Regulatory authorities have provided guidance and support for the transition to alternative reference rates like SOFR. This includes recommending best practices, encouraging market participants to transition existing contracts, and addressing regulatory challenges associated with the transition.
8. Innovation and Product Development: The adoption of SOFR has spurred innovation in financial products and derivatives markets. Market participants are developing new instruments and hedging strategies based on SOFR, leading to a more diverse and robust financial ecosystem.

Disadvantageous of SOFR

1. Volatility and Sensitivity to Market Conditions: SOFR is based on transactions in the overnight Treasury repo market, which can experience volatility, particularly during times of market stress. This volatility can lead to fluctuations in SOFR rates, potentially impacting the pricing and valuation of financial products and contracts linked to SOFR.
2. Lack of Forward-Looking Term Structure: Unlike LIBOR, which provides forward-looking term rates for various tenors, SOFR is primarily an overnight rate with no inherent term structure. While efforts are underway to develop forward-looking term rates based on SOFR derivatives, the absence of a well-established term structure could complicate the transition, particularly for certain financial products and contracts that rely on forward rates.
3. Operational and Technical Challenges: Transitioning from LIBOR to SOFR involves significant operational and technical challenges for market participants. This includes updating systems, processes, and documentation to accommodate the new reference rate. The lack of familiarity with SOFR and its calculation methodology may also require investment in staff training and infrastructure upgrades.
4. Basis Risk and Basis Mismatch: Transitioning from LIBOR to SOFR introduces basis risk, as there may be discrepancies between SOFR and other reference rates or funding costs used by market participants. This basis risk can lead to mismatches in cash flows and valuation, particularly for legacy contracts that reference LIBOR. Managing basis risk effectively requires careful hedging and risk management strategies.
5. Fallback Provisions and Contractual Uncertainty: Transitioning existing contracts from LIBOR to SOFR requires the inclusion of fallback provisions to address situations where LIBOR is no longer available or reliable. However, there is uncertainty surrounding the implementation and effectiveness of fallback provisions, particularly for contracts with complex structures or multiple counterparties. Resolving contractual uncertainty and ensuring consistency across different jurisdictions and market segments is a key challenge.
6. Liquidity and Market Depth: While the Treasury repo market is deep and liquid, other segments of the SOFR market, such as the derivatives market, may lack the same level of liquidity and depth as LIBOR-based markets. This could impact market participants' ability to hedge risks effectively and may lead to wider bid-ask spreads and increased transaction costs.
7. Transition Costs and Disruptions: The transition from LIBOR to SOFR involves costs and disruptions for market participants, including legal, operational, and administrative expenses. These transition costs can be significant, particularly for firms with large portfolios of LIBOR-based contracts. Moreover, the transition process itself could lead to market disruptions and uncertainties, potentially affecting financial stability.

Replacements of LIBOR

Overall, the transition from LIBOR to SOFR is a complex and multifaceted process that requires coordination among market participants, regulatory bodies, and infrastructure providers. While significant progress has been made, the full transition is expected to take several years, and ongoing efforts are required to ensure a smooth and orderly shift to alternative reference rates like SOFR.