From “Watch What They Say” to “Watch What They Do” – Understanding the Interest Rate Benchmark Transition from LIBOR to SOFR

In 1969, a Greek banker named Minos Zombanakis arranged an $80 million loan from Manufacturers Hanover Bank to the Shah of Iran. To establish a basis for his interest rate, he turned to a set of banks and asked them about their respective cost of funds.

From a single loan to hundreds of trillions in credit, what Minos Zombanakis started eventually became the most recognized benchmark for interest rates around the world – the London Interbank Offered Rate, or LIBOR.

As it became more widely relied upon, LIBOR continued to be based on the interest rates that banks would state, in daily submissions to Intercontinental Exchange (ICE, a company that owns financial marketplaces around the world, including the New York Stock Exchange) that they would pay for small-term loans from other banks. For decades it served as the key benchmark in establishing interest rates on adjustable-rate loans, mortgages and corporate debt, eventually totaling hundreds of trillions of dollars.

It worked, until it didn’t.

Fast-forward to the period from 2008-2012, when a series of media and regulatory investigations of LIBOR revealed manipulation of interest rates dating as far back as 2003. As more and more major financial institutions became implicated in the manipulation, LIBOR became less reliable. This lack of credibility heightened the sense of urgency to transition to a new standard. Enter SOFR.

If LIBOR is based on what bankers say, SOFR is based on what they do. SOFR, the Secured Overnight Financing Rate, is a broad measure of the cost of borrowing cash overnight, collateralized by the U.S. Treasury securities in the repurchase agreement (repo) market. Because it is able to reflect the actual funding costs of financial institutions, rather than claims of funding costs, it is considered a more transparent and accurate picture of the market.

Around the world, the transition from LIBOR to SOFR is well underway. The initial announcement of the decision to sunset LIBOR in the United States took place in June of 2017, but the lending market is still working through the changeover.

April 1st of this year, the Consumer Financial Protection Bureau’s (CFPB) LIBOR Transition Rule went into effect, stipulating that mandatory compliance go into effect October 1st, ahead of the end of LIBOR on June 30th, 2023.

By the end of 2021, the first phase of LIBOR cessation had eliminated 24 out of the 35 LIBOR tenors, which are the time periods before a financial contract expires. All non-USD LIBOR tenors, as well as the one-week and two-month USD LIBOR, have ceased publication. Regulators have been facilitating the transition on an ongoing basis by promoting the liquidity and integrity of SOFR. Now, more than 50% of exchange traded interest rate futures contracts are referencing SOFR.

In order to support the seamless transition from LIBOR to SOFR, the Federal Reserve Board and the New York Fed established the Alternative Reference Rate Committee (ARRC). This committee is composed of a diverse group of private-market entities that have a prominent presence in the affected market. The ARRC has developed the Paced Transition Plan, containing supporting tips such as a timeline and specific steps to encourage the use of SOFR. They also recently published a list of recommended best practices to aid in this transition.

Why SOFR?

When LIBOR was still used by numerous banks worldwide, the rate was plagued with a multitude of crises, making it more of a burden than an aid when it came to setting interest rates. While LIBOR is based on bank panel input, SOFR is an overnight secured rate determined solely on transactions, making it less vulnerable to manipulation and more transparent, accurate and credible in how it is set.

What Loans Are Affected?

The impact on each loan is on a person-to-person and bank-to-bank basis. There isn’t a single, clear consensus on how all loans will be handled. As Bloomberg Tax notes, because SOFR is a secured risk-free rate based on overnight transactions and does not incorporate a risk premium, it’s expected that the transition will result in different credit spreads over the selected reference rate. Borrowers will need to examine all documentation referencing LIBOR in any way and work with their lenders to amend and align with the new benchmark.

A borrower with an existing loan does not need to take any action in response to the transition, provided the loan is maturing before the end of LIBOR on June 23, 2023. If the loan is not maturing until after LIBOR has been phased out, the fallback language in the loan documentation will likely provide for an alternative benchmark in the event LIBOR becomes unavailable. Borrowers looking to take out new loans should explore different alternatives to LIBOR and determine if SOFR might be most advantageous to their situation, particularly if they are considering Term SOFR vs. the overnight rate as a borrowing option.

Term SOFR vs. Overnight SOFR

According to Wharton professor of finance Urban Jermann, SOFR does not provide banks with the cushion they got from LIBOR to price in the additional risk they take on in times of crisis. However, SOFR is preferred in times of crisis — it does not have to provide risk insurance because loans based on it are collateralized by government debt.

In early 2020, a group of mid-sized banks expressed their concern with SOFR not being “the one alternative.” The first concern was that SOFR is a secured rate and borrowers will be posting collateral such as U.S. Treasuries, and most of the banks can only borrow on an unsecured basis.

Another concern with the transition has been Term SOFR, which – unlike overnight SOFR – is a proactive rate based on SOFR futures. Tom Deas, chairman of the National Association of Corporate Treasurers, stated that Term SOFR hedging costs are likely to go up more by the end of the year, and if there is another “global disruption” like another pandemic, “that’s when companies will really pay”. But the Alternative Reference Rates Committee (convened by the Fed board and the New York Fed to solicit SOFR transition input from private- market participants) was established to assess issues such as this, and is continually working on ways to reduce the extra costs companies are facing, as well as all other transition-related issues.

Transitioning from LIBOR to SOFR ushers in a new era of transparency, accuracy and reliability. Although the shift impacts financial institutions more than consumers, everyone will benefit from a more resilient and reputable financial system—one where anyone seeking a loan can trust that the SOFR rate published each day by the Federal Reserve Bank of New York represents real rates being paid by real borrowers.

 

About Fieldpoint Private

Headquartered in Greenwich, Connecticut, Fieldpoint Private (www.fieldpointprivate.com) has more than $1.4 billion in bank assets and provides personalized, custom private banking and wealth transfer services. Catering to successful individuals, families, entrepreneurs, businesses and institutions, Fieldpoint Private develops a comprehensive understanding of our clients’ individual financial circumstances and furnishes comprehensive advice and personal service to free up the one resource that regardless of means no one can ever have enough of: time.

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