We recently had friends over for dinner and the topic of Libor came up, as in, “What’s happening with Libor? When is it going to be replaced?” (Before you judge me for having lame dinner conversations: One of the guests is a CPA for a hedge fund, so this was actually an interesting topic!) I realized I’m relatively uninformed on the subject, so I set out to get caught up. Here are three interesting things I came across in my research:
1. The main challenger is SOFR
Quick recap: The US Federal Reserve and other regulators are aiming to reduce reliance on Libor, which underpins more than $370 trillion in financial instruments, such as derivatives and loans. The U.K. Financial Conduct Authority is likely to phase out the scandal-plagued reference rate by the end of 2021 as the data used to calculate the rate isn’t sufficiently robust. (Bloomberg has a great QuickTake explainer with more background.)
In November 2014, the Fed convened the Alternative Reference Rates Committee (ARRC), which includes a broad swath of market participants and regulators. In June 2017, the committee named the Secured Overnight Financing Rate (SOFR) as its preferred alternative reference rate, and the Federal Reserve Bank of New York began publishing rates in early April. The CME Group launched one- and three-month SOFR futures in early May.
What is SOFR?
SOFR is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities. As described by ARRC in its second major report:
SOFR is a fully transactions based rate that will have the widest coverage of any Treasury repo rate available… Because of its range of coverage, SOFR is a good representation of the general funding conditions of the overnight Treasury repo market. As such, it will reflect an economic cost of lending and borrowing relevant to a wide array of market participants active in these markets.
Why did the committee pick SOFR?
The committee calls out four key characteristics of SOFR which support its decision:
- Fully transaction-based (Libor submissions are mostly based on judgment)
- Covers multiple repo market segments allowing for future market evolution
- Encompasses a robust underlying market
- And it represents an overnight, nearly risk-free reference rate that correlates closely with other money market rates
What are the criticisms of SOFR?
Critics don’t like that SOFR is based on secured transactions, rather than unsecured transactions, like Libor.
Second, some market participants are concerned that SOFR is only an overnight rate–there are no terms or tenors, like there are with Libor–and not many people want a floating-rate product that resets every day. In its transition plan, however, ARRC specifically outlines a goal of producing a term rate. The committee also notes that many market participants are already familiar with contracts that reference an overnight rate rather than a term rate.
2. The transition will take lots of legwork
What happens if you have a contract that uses Libor as the reference rate? Most documents for financial instruments tethered to Libor have fallback provisions–but these often just assume there was a temporary interruption in the reporting of Libor, not that the reference rate has gone away altogether.
For example, as of the end of 2016, there were $3.4 trillion in outstanding private-sector loans to U.S. non-financial businesses, of which a large chunk are floating-rate loans tied to Libor. In many cases, the documentation language implies that, in the event Libor is not published, the loans covert to an alternative base rate, often the prime rate. The prime rate, however, is typically well above Libor: In its second report, ARRC notes 3-month Libor is currently near 2% while the prime rate is 4.5%, which would represent a significant increase in borrowing costs.
Borrowers and lenders with Libor-linked instruments will be forced amend their docs to reflect more robust fallback language and/or refer to a specific fallback rate and method to prevent a significant change in borrowing costs–certainly no small feat. Additionally, about 80% of currently outstanding business loans are set to mature before the end of 2021 (the supposed Libor end-date), so consideration will also have to be taken as new loans are initiated.
3. Some people like Libor
This goes back to the fact that Libor is based on unsecured transactions: It represents the rate banks charge each other for short-term loans. FT Alphaville and Bloomberg raise a great point: Libor (which is meant to represent banks’ creditworthiness) goes up in times of stress, while SOFR (which is secured with Treasuries) would go down in times of stress due to “flight to safety” behavior.
Here’s what Canaccord Genuity analyst Brian Reynolds wrote, as reported by Bloomberg:
We call Libor a cockroach because it is not going to go away even though equity investors despise it and regulators want to kill it. It is not going away because fixed income portfolio managers love it. They love it because it is the only interest rate that goes up in a crisis, allowing managers who own floating rate debt based on it to outperform in difficult times because of exposure to corporate credit. We can think of no reason why fixed income investors would want to switch their existing bonds from Libor to SOFR, giving up the prospect of outperforming a financial crisis.