The world of business and technology is continuously changing and evolving. There are always transitions happening, which often means learning and adapting to new systems — as is the case in the USD London Interbank Offered Rate (LIBOR) transition to use the Secured Overnight Financing Rate (SOFR).
The shift to the new benchmark rate is slated to happen by the end of 2021, making it essential to understand the new system and how it will affect your market.
Other major 2020 economic discussions have meant the transition from LIBOR to SOFR may have faded to the background. It is still happening, though, and the change will be here soon. This guide will help you get ready for the transition, breaking down everything you need to know about the shift, why it’s happening, what it means, and who it will impact.
Understanding the Basics of LIBOR
So, what is LIBOR and why do you need to know about it? LIBOR is the world’s most widely used benchmark interest rate for short-term — overnight to one year — loans and is administered by the Intercontinental Exchange (ICE). This reference rate indicates borrowing costs between banks.
A few facts to keep in mind:
- LIBOR is used to make adjustments to variable-rate loans and credit cards.
- It serves as a reference rate for mortgages, government and corporate bonds, consumer loans, derivatives, as well as other financial instruments.
- When loan interest rates change, USD LIBOR is at least partially responsible.
- This is important because LIBOR is used as the basis for consumer loans, which means it impacts consumers and financial institutions all over the world.
LIBOR is determined by the ICE Benchmark Administration (IBA), which uses a trimmed mean approach calculated with data it receives from global panel banks. The list of financial institutions involved includes Bank of America, Barclays, Citibank, Deutsche Bank, JPMorgan Chase, and UBS.
Why Has LIBOR Lost Favor?
LIBOR has been the leading benchmark interest rate for short-term lending since its inception in 1984, but transactions that use it began to decrease following the financial crisis in 2008. The crisis and subsequent decrease in transactions prompted an investigation that led officials in the United States and United Kingdom to uncover a crucial fact:Traders had been manipulating LIBOR for both bank and personal profit.
The result was billions of dollars in fines for banks and prison sentences for the traders found guilty. The scandal made it apparent that there was a need for a switch to a different benchmark that would be less easily manipulated.
How SOFR Will Change Things
SOFR is a secured interbank overnight interest rate used as a benchmark for dollar-denominated derivatives and loans. It is a comprehensive measure of the overnight borrowing costs of cash with Treasury securities as collateral.
A few important notes about it and its role:
- SOFR is replacing LIBOR.
- It is anticipated that this switch will increase long-term liquidity, although it is expected to cause considerable short-term volatility in trading derivatives.
- The greatest impact of the switch will be on the derivatives markets.
- It will also influence consumer credit products such as adjustable-rate mortgages and private student loans.
- In terms of adjustable-rate mortgages based on SOFR, it will affect the borrowing rates once the fixed interest-rate period is over.
- If SOFR is higher when the fixed-rate ends, borrowers will pay more.
- If it is lower, borrowers will pay less.
SOFR is calculated by taking a volume-weighted median of transaction-level tri-party repo data obtained from the Bank of New York Mellon, GCF Repo transaction data, and data on bilateral Treasury repo transactions cleared through FICC’s DVP service.
The LIBOR to SOFR Transition
The switch was called for following the aforementioned investigation’s findings. LIBOR increasingly became based on estimates following the 2008 crisis-related economic decline. In contrast, SOFR is a secured daily rate with numbers based on observable daily trading activity with a volume over $1 trillion. It is seen as more stable and less easily manipulated, too, making it an ideal replacement benchmark.
Change doesn’t happen overnight, though, and the transition to SOFR is no exception. It will require a major cooperative effort, but experts believe it will lead to a far more resilient financial system. This is because:
- The publication of LIBOR will not be guaranteed after 2021.
- The Alternative Reference Rates Committee (ARRC) has identified some best practices and a paced transition plan with actionable steps to be taken.
- The ARRC includes the Federal Reserve Board of Governors and the New York Fed working with the U.S. Department of the Treasury, Commodity Futures Trading Commission (CFTC), and Office of Financial Research (OFR) to identify an alternative reference rate for use primarily in derivatives contracts.
As the shift continues, the ARRC offers updated information and guidance regarding the changes taking place. Although initial adoption was slow, investments have since been increasingly using SOFR as their reference rate.
Concerns about SOFR to Watch For
LIBOR’s expiration is looming and SOFR is becoming preferred, but there are still some questions out there. These include:
- Issues with the fallback language used as well as the effect the final and complete transition may have on markets.
- That the impact of the shift is not uniform across credit markets.
- That the most acute issues in the transition away from forward-looking term rates like LIBOR lie in cash markets, and especially in structured finance.
- That adaptation of new interest rates brings up questions about the possibility of value transfer between lenders and borrowers in securitizations.
The prospect of shifting to a new reference rate may seem daunting for many market participants, but overall using SOFR can help build a more stable and secure system. Understanding the rates and how they impact markets is the first step in determining how the shift will affect you. Following a paced transition plan can help you make the switch more smoothly.
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