LIBOR, the London Interbank Offered Rate, is the most referenced short-term interest rate index and serves as a benchmark to adjust rates on hundreds of trillions of dollars’ worth of financial contracts and securities, including adjustable-rate mortgages, consumer loans and corporate debt. After the 2008 financial crisis, the integrity of LIBOR and other indices was undermined by alleged manipulation. In response, a global reform effort began to transition interest rate benchmarks towards more robust market-based indices. LIBOR, in particular, is expected to be discontinued by the end of 2021. For dollar denominated instruments, the recommended alternative to LIBOR is the Secured Overnight Financing Rate (“SOFR”), which is being managed by the Alternative Reference Rates Committee (“ARRC”) convened by the Federal Reserve Board and the Federal Reserve Bank of New York. This transition away from LIBOR presents significant challenges.
LIBOR rates are intended to reflect current and expected future financial market conditions. A panel of contributing banks submits daily interest rates in response to the question: “[a]t what rate could you borrow funds, were you to do so, by asking for and then accepting interbank offers in a reasonable market size just prior to 11:00 GMT?” LIBOR submissions can be based on both actual transactions data and “expert judgment,” the latter to be used when the respondent bank has limited actual data on which to base its submission.
The shortcomings in the methodology for constructing LIBOR became apparent after the 2008 financial crisis. The widespread availability of central bank liquidity after the crisis and a general reassessment of interbank risk led to lasting reductions in the volume of interbank lending. As a result, fewer LIBOR submissions were made by contributing banks, and those that were made became more heavily reliant on expert judgment, rather than on actual market transactions. The fundamental weaknesses in the construction of LIBOR culminated in numerous instances of LIBOR manipulation through deliberately distorted submissions.
In response to these challenges, in 2014 the Intercontinental Exchange Benchmark Administration took over the management of the LIBOR process and implemented numerous reforms. Among other changes, an improved submission methodology was adopted (the “Waterfall Methodology”) that prioritizes transaction-based data and transaction-derived data, and reduces reliance on expert judgment. This approach balances the desire to favor transactions data with the need to provide a broad range of rate benchmarks. Implementation of this new methodology, however, did not overcome the lack of market data for certain currencies and tenors, resulting in continued heavy reliance on expert judgment.
LIBOR’s methodological shortcomings, and concerns about the integrity of interest-rate benchmarks more generally, led to a global effort to transition to market-based reference rates and to a phasing out of LIBOR by the end of 2021. For dollar denominated instruments, the recommended alternative to LIBOR is SOFR. SOFR is a measure of the cost of borrowing cash overnight secured by U.S. Treasury securities. The rate is derived from overnight repurchase agreement (or repo) transactions and is published daily at 8:00 AM. Eastern Time. SOFR is calculated as a volume-weighted median rate – the rate at the 50th percentile of the dollar volume – and was first published in 2018. As such, SOFR is built on an active market and relies on transactions data that enhance the integrity of the index.
There are significant differences between SOFR and LIBOR. First, SOFR is based solely on directly observable transactions data and is thus less susceptible to manipulation. LIBOR, in contrast, relies on both market data and the expert judgment of the submitter and can be more easily manipulated. Second, SOFR is based on borrowing secured by U.S. Treasury securities and thus is a risk-free rate that fails to account for interbank credit risk. LIBOR rates, on the other hand, measure the cost of unsecured borrowing and thereby reflect interbank credit risk. Third, SOFR is an overnight backward-looking rate calculated at the end of a borrowing period, whereas LIBOR rates are prospective and assessed for a variety of forward-looking terms. LIBOR thus reflects a term structure of forward-looking interest rates that can be applied to financial contracts. While past SOFR rates can be used to compute a term structure in arrears, this type of arrangement lacks the certainty afforded to counterparties by a forward-looking term structure. As an alternative, forward-looking SOFR rates can be developed from actively-traded SOFR derivatives markets, which depend on sufficiently large trading volumes to be robust and reliable.
The transition away from LIBOR not only involves identifying a robust new benchmark for new contracts, but also redefining the terms of existing financial instruments linked to LIBOR that will remain outstanding after 2021 (“legacy contracts”). Legacy contracts account for approximately $35 trillion in financial instruments. Adjusting the terms of such contracts post- LIBOR presents significant challenges. An alternative benchmark, for example, may imply bigger or smaller payments than under LIBOR and require establishing terms to maintain the valuation of the financial instruments at issue. As a risk-free rate, SOFR is generally lower than LIBOR, and the transition of contracts from LIBOR to SOFR will require compensation to maintain the valuation through a one-time payment or an adjustment to spreads. Adjusting SOFR rates via an estimated credit risk premium derived from market yields may not be a practical solution as a lack of liquidity in certain markets is a reason for the transition away from LIBOR. To address these challenges, ARRC developed a Paced Transition Plan that delineates a timeline to foster adoption. This plan includes a recommended SOFR plus-a-spread adjustment as a statutory fallback.
Overall, the goal of the transition is to provide some certainty in the event of LIBOR cessation by providing a statutory non-LIBOR alternative that approximates the terms of the initial agreement. However, the migration away from LIBOR to SOFR may still result in uncertainty and give rise to significant legal disputes.