LIBOR (an acronym for the London InterBank Offered Rate) is the primary benchmark interest rate set for various durations and currencies each business day in London.
LIBOR is a hypothetical rate based on a daily survey of banks as to where they would lend to other banks for the various tenures from overnight to one year, on an unsecured basis. LIBOR is hence not based on actual transactions and financing rates, and it includes an implied credit component.
LIBOR is a so-called "term" rate, meaning once it is set, it applies for the full term of the LIBOR maturity chosen, for example for one, three, or six months. At the end of the chosen maturity, interest payments are paid, applying the LIBOR rate that was set in advance for the entire calculation period. Thus, interest expense for the payment period is known with certainty at the beginning of the calculation period but paid at the end, or "in arrears."
U.S. dollar ("USD") LIBOR is used as a reference interest rate index for more than $200 trillion in notional amount of financial contracts in the cash and derivatives markets. Though 78% of USD LIBOR-referenced instruments mature before the EOY 2021, the date by which regulators will not allow any further USD LIBOR-based financial transactions, that still leaves tens of trillions of U.S. dollars in "legacy", or still outstanding, notional value to be remedied across numerous forms of financings.
Why is LIBOR being terminated and replaced as a reference rate?
In the wake of the 2008 Great Recession financial crisis, regulators discovered that the very banks trusted to set LIBOR rates, underpinning hundreds of trillions of dollars of financial assets in several currencies, had been manipulating LIBOR to their own advantage. In 2012, this unfortunate LIBOR scandal was exposed. The scheme involved bankers at many major financial institutions manipulating LIBOR surveys for the purposes of profit. This corrupt plot undermined LIBOR as a major benchmark for interest rates and financial products.
Even before this scandal, regulators had been pushing to replace LIBOR as a reference-rate benchmark, with a more objective, market-based rate.
The current reference rate reform is an international effort, and the need to transition away from LIBOR to alternative reference rates is not limited to just USD LIBOR. Most major currency jurisdictions have identified a need for reforming their major interest rate benchmarks.
When will the transition away from LIBOR occur?
Since as early as 2017, global regulators and financial authorities have maintained that all LIBOR indices would be phased out by the end of 2021 and transitioned to alternative reference rates in their respective currencies. However, some of these entities have given ground by delaying the USD LIBOR transition by 18 months. The Intercontinental Exchange's ("ICE's") Benchmark Administration ("IBA") said it would cease publication of one-week and two-month USD LIBOR by the end of 2021. All remaining USD LIBOR tenors, which are more commonly used, will now remain until the end of June 2023.
While U.S. officials are adamant that it is only a temporary lifeline, many see the move as an acknowledgment that the proposed transition has been more daunting than originally envisioned. While waiting until 2023 to end key USD LIBOR tenors does not solve the problem of legacy financial contracts, it should at least allow for many to expire naturally while policy makers discourage new LIBOR-linked transactions beyond the end of next year. For example, the 18-month delay to three-month USD LIBOR alone will enable roughly 80% of all investment-grade, USD floating- rate notes to mature before the new cutoff date.
Authorities are making it clear that the revised 2023 deadline only applies to existing USD LIBOR contracts and that markets should stop using USD LIBOR as soon as practicable, implying that no new USD LIBOR-based contracts should be executed after 2021. The U.S. Federal Reserve ("Fed") has stated that any new USD LIBOR contracts would be viewed as "unsafe and unsound practice" if transacted beyond the end of 2021, and that the central bank would "supervise such firms accordingly."
LIBOR extensions were not proposed by the IBA for the index's other currencies — namely in euro, sterling, Swiss franc, and Japanese yen - a reflection of the heavier usage of the U.S. dollar index in global financial contracts. Users of LIBORs in other denominations have been told by their regulators to proactively shift the pricing of legacy contracts to alternative rates set by their respective central banks before the end of 2021, or risk ending up in a legal conundrum.
In fact, on March 5th, 2021, global regulators officially kicked off the final countdown for these various LIBORs. The U.K. Financial Conduct Authority confirmed that the final fixings for IBOR rates, except for the USD LIBOR rates that have received the 18-month extension, will take place after December 31st, 2021. This announcement on March 5th serves as the formal "cessation event" and locks in the various benchmarks' fallback spreads. Where firms have adhered to the ISDA protocol, their derivative contracts will automatically transition to the newly defined ISDA replacement rates the moment their particular LIBORs end after December 31st, eliminating any uncertainty or ambiguity in their transactions.
Who will have to transition away from LIBOR?
An entity with any financial transaction that references USD LIBOR will have to transition away from it if it is not set to mature prior to the end of June 2023 when most USD LIBOR term rates will cease to be calculated and published. This puts the entity into a legacy position and in need of a fallback language provisions to replace any reference to USD LIBOR. Regulators and financial authorities are not willing to allow any new USD LIBOR-based financial transactions past the end of 2021.
"Fallback language" refers to the legal provisions in a contract that apply if the underlying reference rate in the financial transaction is discontinued or unavailable. Fallback provisions are essentially instructions on how to convert and apply one reference rate to another.
Who is overseeing this LIBOR transition?
The Financial Conduct Authority ("FCA") in the U.K. is the regulatory entity calling for the cessation of all LIBORs. Their termination is planned for the end of 2021, with the exception of USD LIBOR term rates (excluding only one-week and two-month USD LIBOR tenures), which are now planned to terminate at the end of June 2023.
In the U.S., the Fed convened the Alternative Reference Rates Committee ("ARRC") with representatives from the Fed and a diverse set of private-sector entities that have an important presence in the USD LIBOR markets (such as banks, clearing houses, insurance companies, and the International Swaps and Derivatives Association, or "ISDA") and a wide array of official-sector entities, including banking and financial-sector regulators.
The ARRC was established to identify an alternative reference rate based on a robust underlying market with actual transactions and strong volumes and activity; take into consideration the plight of end-users of USD LIBOR; develop standards; and, to enable a smooth-as-possible transition.
The rate chosen by the ARRC to replace LIBOR is the Secured Overnight Financing Rate ("SOFR").
SOFR is the repurchase rate ("repo rate") at which money can be borrowed overnight by posting a Treasury note or bond as security. Given the short tenor (overnight) and high quality of collateral (Treasuries), the rate deemed to be risk-free and track the Federal Funds rate.
The ARRC selected this rate because of the depth of the secured, overnight lending market and its resiliency to closely track the Federal Funds rate in various economic environments and shocks.
In terms of the transactions underpinning SOFR, it has the widest coverage of any Treasury repo rate available. The transaction volumes underlying SOFR are far larger than the transactions in any other U.S. money market. It is widely believed that SOFR will properly reflect an economic cost of lending and borrowing relevant to the wide array of active market participants.
The New York Fed is the administrator and producer of SOFR. The New York Fed publishes SOFR daily on it's website at approximately 8:00 a.m. ET.
In summary, SOFR is:
What are the differences between LIBOR and SOFR?
SOFR is a risk-free rate that tracks very closely to monetary policy. LIBOR is a bank risk rate that tracks very closely to credit events, specifically relating to banks. In times of financial stress, SOFR may decrease and LIBOR may increase, for example, because LIBOR better tracks a bank's liabilities and risks. Banks have enjoyed this extra security and may find it challenging to replace.
SOFR is an overnight rate and LIBOR is a term rate. LIBOR sets in advance and is paid in arrears. Hence, both counterparties to the transaction know in advance what interest will accrue in the current period. SOFR can be averaged or compounded, but either way, it will be calculated and set in arrears, thus not offering the same upfront certainty as LIBOR until the end of the current calculation or payment period.
No term market exists in the repo market, but this is starting to develop through SOFR futures contracts, long-dated SOFR interest rate swaps, and SOFR-based bonds. The Treasury is considering issuing SOFR based notes and bonds. The more that longer-dated SOFR transactions get issued, the more data there will be to build a term structure, or a forward curve, for SOFR. This is a major market concern and one of the many reasons that many market participants called for the eventually granted delay in the USD LIBOR transition.
What are some of the issues with SOFR as a reference rate?
As discussed in the question and answer above, there is not a deep, liquid forward market for term SOFR rates.
Systems that capture, calculate, and provide rate related information (as they do now for LIBOR) will all have to be modified to account for SOFR. This endeavor is not expected to equal the amount of effort nor cost as seen with the global Y2K project prior to the year 2000, for example, but nevertheless the estimated cost to the world's largest 14 banks alone for this LIBOR transition will be over $1.2 billion.
Timing is of great concern, as well. While all financial institutions are working on the LIBOR transition at various stages, it is unknown whether everyone, both financial institutions and end-users, will be prepared for the transition, even with the granted delay for USD LIBOR to the end of June 2023. For any party that has not transitioned away from LIBOR and LIBOR ceases to exist, they will find themselves in a "zombie" position to which the answers, particularly the legal answers, are not clear today on how to deal with such a scenario.
There is a real chance of losing, or gaining, from the LIBOR-to-SOFR basis for those who do transition. All interested bodies that are overseeing and/or playing a role in the LIBOR transition are doing everything they can to eliminate this basis risk, but there will undoubtedly be some amount of transfer of value when LIBOR transitions to SOFR.
SOFR is considered by some to be too volatile a rate to be used as a benchmark. SOFR has been volatile at times when the underlying U.S. Treasury repo market has been volatile. However, comparing an overnight rate to a term rate is not a like comparison. While it clearly is the case that SOFR and other overnight repo rates are inherently more volatile than term rates on a day-to-day basis, it is important to remember that contracts referencing SOFR will be based on averages and/or compounding of these daily rates. Therefore, SOFR would be smoothed across a longer period, diluting any large single day variances. The ARRC's Second Report (Figure 5 of the report) emphasizes this point, showing that a three-month average of overnight Treasury repo rates has historically been less volatile than three-month USD LIBOR over a wide range of market conditions.
Is it possible that another rate besides SOFR will serve as the replacement for USD LIBOR?
Yes, given the recent news that U.S. banking regulators said financial institutions can choose any reference rate to replace USD LIBOR, and that the use of SOFR is voluntary. In a joint statement, the regulators have said that "a bank may use any reference rate for its loans that the bank determines to be appropriate for its funding model and customer needs." The statement went on to say that "the agencies recognize that banks' funding models differ and that in structuring their lending activities it is appropriate for banks to select suitable replacement rates for LIBOR that are most appropriate given their specific circumstances."
These statements do not mean that the transition from the regulators' preferred USD LIBOR replacement, SOFR, will stop. Rather, they came after multiple small and midsize banks earlier this year told the Federal Reserve, Federal Deposit Insurance Corp., and Office of the Comptroller of the Currency that SOFR was ill-suited to them since they do not have many ties to the repo market. They argued SOFR was more appropriate for larger banks. Some banks have also expressed concern that SOFR could result in a "mismatch" between bank assets and liabilities in the event of economic stress.
USD LIBOR may be replaced by a fallback rate that already occurs in existing financial contracts, for example with a lender's prime rate, which is often contained in many loan agreements.
Many small and midsize banks prefer AMERIBOR as the USD LIBOR alternative, as SOFR is seen by these banks as being too complicated for their clients and too difficult and costly to administer. AMERIBOR is calculated from the actual borrowing costs between the banks that are members of the American Financial Exchange. Thus, AMERIBOR includes a credit component and better represents these banks' actual funding costs. AMERIBOR futures are already trading on the Cboe Futures Exchange.
Bloomberg began publishing the Bloomberg Short Term Bank Yield Index ("BSBY") on an indicative basis on October 15, 2020, to serve as a supplement to SOFR and support the global transition away from the LIBOR. The index will be calculated and published at 8 a.m. New York time and is available across five tenors: overnight, one-month, three-month, six-month, and 12-month terms. BSBY is constructed using aggregated and anonymized data based on transactions of USD commercial paper, certificates of deposit ("CDs"), bank deposits, and short-term bank bond trades, reflecting banks' marginal funding costs. Rate includes a systemic credit spread and term structure.
Alternatively, the U.S. Dollar ICE Bank Yield Index was introduced by LIBOR's administrator, ICE. ICE's IBA introduced this alternative in a January 2019 white paper. This new index, developed specifically as a potential replacement for lending activity tied to USD LIBOR, has multiple tenors (one-month, three-month, and six-month terms) as well as the credit component SOFR lacks. Since the IBA created the U.S. Dollar ICE Bank Yield Index, it has since published four updates to inform market participants on the details of its proposed methodology as it has evolved, to provide testing results, and to seek feedback.
How will the transition from LIBOR be initiated?
The United Kingdom's FCA is responsible for regulating all LIBORs. FCA Chief Executive Andrew Bailey has made clear that the publication of LIBOR rates is not guaranteed beyond 2021, with the exception of most USD LIBOR rates that will now continue through the end of June 2023.
The fallback from LIBOR is triggered when there is a public statement that the relevant administrator ceases to provide LIBOR permanently or when its regulatory authority (FCA) deems LIBOR to no longer be representative. Such events are referred to as "trigger events" and are further defined for derivatives in the updated ISDA definition amendments.
A one-page statement on how the FCA would announce LIBOR cessation trigger events can be found here.
How do I transition from LIBOR?
Currently, there are three primary methods being developed to transition from LIBOR:
For legacy derivative transactions that reference USD LIBOR, ISDA released its 2020 IBOR Fallbacks Protocol, created to enable counterparties to adhere to the amendments made to the 2006 ISDA Definitions to provide for fallback provisions to replace reference rates that will cease and need to be transitioned. For USD LIBOR, the replacement rate is SOFR. Fallback provisions are essentially instructions on how to convert and apply one reference rate (e.g., USD LIBOR) to another (e.g., SOFR):
In these newly amended definitions (see pages 17-26), a spread will be applied to SOFR to make the updated transaction as equivalent as possible to the counterparties' respective positions of value when USD LIBOR was being applied prior to the transition, as daily, risk-free SOFR rates trade below term, credit-based LIBORs.
Adhering to the 2020 IBOR Fallbacks Protocol means agreeing to the updated floating-rate option definitions with their fallback provisions per the ISDA amendments. Both counterparties will have to adhere to this ISDA protocol for the newly updated ISDA definitions' fallback provisions to be applicable.
Any new derivative transaction that takes place after January 25, 2021, will incorporate the new fallback provisions if the counterparties have both adhered to the protocol or bilaterally agree to include the new fallbacks into their contracts.
For non-derivative legacy transactions (such as loans), or for derivative counterparties that do not dually adhere to the ISDA protocol for legacy derivative transactions, another method of transitioning from LIBOR would be through a bilateral agreement among the counterparties. In the case of many loans, a fallback to a Prime rate is common and can be a LIBOR transition solution instead of negotiating a bilateral agreement or transitioning to SOFR.
The transition from LIBOR is an undertaking which many will need specialized expert support. The AEGIS Interest Rate Advisory team is available to provide the guidance needed with these transition related concerns as well as with all interest rate risk and hedging related needs.