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SOFR rate

Introducing SOFR: Benefits and Challenges of the LIBOR Replacement

A Look Back at LIBOR, a Look Forward to SOFR

In June 2023, LIBOR, the London Interbank Offered Rate, which has a tremendous influence on how U.S. interest rates are set, will be replaced by SOFR (Secured Overnight Financing Rate). While the cessation deadline for LIBOR was originally December 2021, many tenors of USD LIBOR will now continue to be published into the new deadline.

Here’s what you should know about LIBOR and its replacement, SOFR.

History of LIBOR

LIBOR is a benchmark that indicates the global, average interest rate at which major banks can borrow from one another. It is used around the globe for a multitude of financial contracts, including consumer and business loans, asset-backed securities, municipal bonds and other derivatives.

Issued by the Intercontinental Exchange Benchmark Administration Limited (ICE), 35 LIBOR rates appear each day, reflecting interbank borrowing costs for various periods of time, from overnight to one calendar year. The LIBOR rate covers five major world currencies (U.S. dollar, British pound, euro, Swiss franc, and Japanese yen) with seven different maturities quoted for each.

London’s status as an international financial center helped solidify its banking practices as a standard for measure back in the 1980s, when people were looking for accuracy and reliability in calculating interest rates. At that time, the British Bankers’ Association (BBA) administered LIBOR. Other major international banking hubs have methods similar to LIBOR, like Tokyo (TIBOR) and Europe (EURIBOR).

How is LIBOR Calculated?

Each day, the ICE Benchmark Administration conducts a poll of several banks, asking “At what rate could you borrow funds, were you to do so by asking for and then accepting inter-bank offers in a reasonable market size, just prior to 11 a.m.?” From there, responses are averaged and published by Thomson Reuters by 11:30 a.m. (GMT).

The Problem with LIBOR

In the last several years, LIBOR has come under fire for two main reasons:

  • A 2012 investigation found that major banks—more specifically, Deutsche Bank, Barclays, UBS, Rabobank and the Royal Bank of Scotland—were inaccurately reporting numbers and manipulating LIBOR rates for financial gain. This behavior began as far back as 2003.
  • In 2017, the Financial Conduct Authority (FCA) determined that LIBOR was unsustainable due to a lack of activity in the market for which to adequately base rates.

Add in the UK’s BREXIT transition, and you have a recipe for one obsolete benchmark.

In the meantime, the Federal Reserve Bank has been developing a LIBOR replacement: SOFR.

What Is SOFR?

SOFR is a benchmark that measures the cost of borrowing cash overnight. It is reported daily by the Federal Reserve in New York at 8 a.m. ET. Unlike LIBOR, which is unsecured (i.e., non-collateralized), SOFR is collateralized by U.S. Treasury securities and based on repurchase transactions backed by the U.S. Treasury. While LIBOR is forward looking, SOFR looks back at the previous night.

Note: SOFR will affect variable rate loans, but it will not affect fixed-rate loans.


What makes SOFR a safer alternative to LIBOR?

  • SOFR is based on a higher volume of daily trades each day (totaling roughly $977 billion USD), which benefits the accuracy of the benchmark.
  • Unlike LIBOR, SOFR is a risk-free, secured rate, so credit risk premiums are not included in the rates.
  • SOFR provides reliability, as it is based on observable transactions, whereas LIBOR is based on rates that financial institutions claim they would offer.

The challenge, however, is in a lack of forward-looking rates. As a backward-looking rate, the borrower does not know the rate at the beginning of the period—i.e., not until it is time to pay. Currently, daily compounded SOFR or “SOFR in arrears” is the preferred rate, which compounds the daily overnight rate.

A forward-looking or “term SOFR”, derived from SOFR futures and overnight swaps market transactions, would determine the rate for the future one-, three- or six-month period. The term rate would act similarly to LIBOR. Due to a less robust swaps market, an effective forward-looking SOFR has not yet been produced, and may not be available in 2021 or in time for the LIBOR transition.

Global LIBOR Replacements

In addition to SOFR, global markets are creating their own LIBOR replacement benchmarks. The UK has chosen SONIA, the European Union has opted for ESTER (to replace EONIA/Euribor) and Japan will be using its own rate, TONAR.

[Editors’ Note: To learn more about this and related topics, you may want to attend the following webinar: Basic Concepts Applicable to All Borrowers & Lenders. This is an updated version of an article that was originally published on February 20, 2014.]

©All Rights Reserved. June, 2021.  DailyDACTM, LLC d/b/a/ Financial PoiseTM

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