By Annie Scott, Catalyst Strategic Solutions Manager of ALM Data and Model Administration
Night fades to morning, morning turns to night. With each passing day comes change – a constant cycle that also holds true in the world of investments.
As you may know, the London Interbank Offered Rate (LIBOR) is being phased out in the U.S. and replaced with a new benchmark rate, effective June 2023. Around since the
mid-1980s, the LIBOR index has had a pretty good run as the dominant benchmark for dollar-denominated derivatives and credit products for decades.
But now, like the rising and setting of the sun, we’re amidst a transition. As LIBOR’s replacement – the Secured Overnight Financing Rate (SOFR) – becomes more visible, here’s what you need to know.
Sun setting on LIBOR
Why are we saying goodbye?
First, a little background. The LIBOR index is made up of five currencies: the U.S. dollar, the euro, the British pound, the Japanese yen and the Swiss franc. The rate is primarily based on survey estimates from major global banks, rather than actual transactions.
In 2012, it became apparent that some institutions were altering data to improve profits from their LIBOR-based derivatives products. Banking regulations at the time made interbank borrowing somewhat difficult, so trading activity became limited and fears surrounding LIBOR’s reliability grew. Ultimately, British regulators announced they would stop requiring banks to submit their lending information after 2021, prompting a global search for an alternative index. In 2017, the Federal Reserve assembled the Alternative Reference Rate Committee (ARRC) to establish a replacement on behalf of the U.S. As a result, the committee settled on SOFR as the new benchmark for dollar-denominated contracts.
SOFR emerging on the horizon
How does this interest rate standard differ?
SOFR is based on observable data from transactions in the Treasury repurchase market, where there is extensive trading, versus estimated borrowing rates. It will become the nation’s new benchmark rate for pricing loans for businesses and consumers. The “overnight” component of its name refers to how the rates for lenders will be set: they will be based on the rate large financial institutions pay for other overnight loans. Financial institutions lend money to each other using Treasury bond repurchase agreements, or “repos.” These agreements let banks make overnight loans to satisfy liquidity and reserve requirements using Treasury bonds as collateral. By using actual transactions, SOFR will be more reliable than LIBOR and less vulnerable to insider manipulation.
Other notable differences exist between LIBOR and SOFR, starting with loan type. LIBOR represents unsecured loans, while SOFR is backed by Treasury bonds and, therefore, is arguably risk-free. Additionally, LIBOR has over 30 different rates, whereas SOFR currently publishes only one rate based on overnight loans.
What lies ahead?
So glad you asked.
At this time, the two benchmark rates will coexist; however, SOFR will eventually supersede LIBOR for investing and lending. Many financial institutions have already begun transitioning some of their investments and consumer products to SOFR. The process of transitioning contracts to the new index should be simple, but may hold a few surprises. Trillions of dollars’ worth of LIBOR-based contracts still exist, some of which aren’t set to mature until after the 2023 sunset date.
To prepare, regulators encourage financial institutions to do the following:
- Include a “fallback” clause in all new contracts, outlining how the difference between SOFR and LIBOR will be calculated.
- Determine LIBOR risk exposure and use that analysis to develop a transition plan.
If your credit union has been following a “wait and see” approach, I encourage you take the necessary first steps now. The sun is slowly setting on LIBOR.
Catalyst Strategic Solutions stands ready to help you with this transition. For more information, contact our team of experienced ALM consultants today.