1. Who is ARRC?
ARRC is a group of private market participants, convened in 2014 by multiple U.S. agencies, including the Federal Reserve Board and Federal Reserve Bank of New York. Their goal was to identify risk-free alternative reference rates for U.S. dollar LIBOR and best practices to support an orderly adoption.
2. LIBOR – What, Why and When
The LIBOR reference rate has been the prevalent rate for most adjustable-rate financial products. Unfortunately, international investigations into LIBOR, which began in 2012, revealed widespread efforts to manipulate the rate for profit, with issues discovered as far back as 2003. As a result, the validity of LIBOR has been challenged, and LIBOR-based transactions between banks have steadily dwindled. In July 2017, Andrew Bailey, chief executive officer of the Financial Conduct Authority – United Kingdom’s regulator that oversees financial firms and the LIBOR panel – stated the regulator cannot guarantee LIBOR’s availability beyond 2021. Thus, LIBOR is scheduled to sunset at the end of 2021.
As a result, regulators are strongly encouraging adoption of a LIBOR alternative earlier than year-end 2021 to minimize market disruptions.
3. SOFR – What and When
Specific to identifying U.S. dollar LIBOR alternatives, ARRC needed to ensure the recommended rate was robust, IOSCO (International Organization of Securities Commission) compliant, transaction-based and derived from a deep and liquid market. Based on those criteria, ARRC recommended SOFR.
4. Some Key Differences Between LIBOR and SOFR:
- SOFR is a broad measure of the cost of borrowing cash overnight, securitized by U.S. Treasury securities. It is calculated by taking the volume-weighted median transaction level of repo data collected from numerous sources. SOFR is published daily by the New York Federal Reserve on their website.
Conversely, LIBOR is a global benchmark for unsecured, short-term interest rates, used to price derivatives, bonds and loans. LIBOR is a collection (average) of interest rates that large, global banks charge to borrow from one another. The interest rates are compiled from loans with seven different maturities and covering five major global currencies. The Intercontinental Exchange Benchmark Administration (ICE), which took over administration of the rate in 2014, surveys 11-18 banks for their rates, then removes the highest and lowest quartile interest rates and averages the remaining rates.
- The integrity of the published LIBOR rate is dependent upon bank submissions and expert judgment in setting a forward-looking rate on short-term borrowings. These submissions and judgments can be subject to biases on the predictive future of rates. SOFR, on the other hand, is based on actual transactional data (backward-looking) and does not depend on forward looking rates.
- The term structure for LIBOR includes multiple maturities, such as one week, one month, three months, etc. SOFR is based on a single overnight maturity, however, a term structure of rates is in development.
- The depth of the SOFR market is based on approximately $1 trillion posted transactions per day (repo markets), while the LIBOR market is based on approximately $1 billion posted transactions per day (at the 3-month maturity, the most active tenor). The depth of the SOFR market makes the rate difficult to manipulate or influence, and the market should remain active enough that SOFR can be readily produced in a wide range of economic conditions.
- SOFR is calculated based upon the repo market, which is securitized by U.S. Treasury securities, and it is assumed to have no credit risk. This establishes a true “risk-free” rate. LIBOR is calculated based on a bank(s) unsecured lending rate to other entities and is assumed to include credit risk.
5. What is impacted with the change from LIBOR to SOFR?
In the U.S., it is estimated that more than $200 trillion in financial contracts (derivatives), loans and securities are tied to LIBOR. Most financial institution’s variable rate loans (including credit cards) are tied to either LIBOR or the Prime Rate. Financial institutions that use interest rate hedging strategies have instruments tied to LIBOR. While issuance of loans and securities tied to SOFR is growing, trading in futures and swaps tied to SOFR remains tepid, and firms are still working to craft fallback language for longer-term contracts tied to LIBOR.
6. Can we continue to use LIBOR?
The integrity of the LIBOR index will greatly diminish after 2021. Global regulators are encouraging their respective central banks to find an alternative to LIBOR. The U.S. has chosen the SOFR index as the alternative to LIBOR. Financial institutions have been advised to begin taking steps to address the issuance and purchasing process of products currently linked to LIBOR.
7. Considerations for Credit Union Policies
Credit unions should review investment, lending and ALM policies for guideline language referencing LIBOR, and substitute with an alternative index where applicable.
Ultimately, the transition from LIBOR to SOFR will bring forth changes. Credit unions are encouraged to review loan categories, investment securities and member share products that may be affected by this change.
Catalyst Strategic Solutions’ team of experienced advisors offers a wealth of knowledge on a variety of ALM and Advisory services. Contact us to find out how they can help your credit union prepare for success this year!
Helpful SOFR resources:
ARRC Releases a User’s Guide to SOFR
A User’s Guide to SOFR