What you need to know about the changes coming to this short-term interest rate benchmark.
What is LIBOR?
LIBOR, short for London Interbank Offered Rate, has served as the benchmark interest rate for short-term unsecured loans between major global banks since the 1970s.
Published each day by the ICE Benchmark Administration (IBA), LIBOR is calculated for five currencies: the U.S. Dollar, the Euro, the British Pound, the Japanese Yen and the Swiss Franc. Rates are issued for seven different terms, ranging from overnight to 12 months.
How is LIBOR used?
LIBOR underpins interest rates worldwide on everything from credit cards, student loans and variable rate mortgages, to interest rate swaps, floating rate CDs, collateralized debt obligations and syndicated loans.
LIBOR is used by the Federal Reserve and other nations’ central banks to gauge market expectations for interest rates. It is also viewed, among other things, as an indicator of overall banking system health.
Why is it changing – and when?
For years, regulators worldwide have raised concerns that LIBOR is an unreliable benchmark because it is not based on a significant volume of observable transactions. The interbank submissions of just 16 financial institutions, for example, are used to calculate the US Dollar LIBOR. Some of these banks have been accused in the past of colluding to manipulate LIBOR rates.
In 2017 the U.K. Financial Conduct Authority, stated that it would not compel LIBOR panel banks to make submissions to determine LIBOR rates after 2021. The Alternative Reference Rates Committee (ARRC), convened by the Federal Reserve Board and the New York Federal Reserve Bank to seek alternatives to LIBOR, has recommended a new index – the Secured Overnight Financing Rate (SOFR) – as the new benchmark for U.S. bond and loan market transactions. The New York Federal Reserve Bank now publishes the SOFR daily, as well as SOFR Averages and a SOFR Index. The number of SOFR-linked products is gradually growing.
The ARRC’s goal is to assist financial institutions in completing the transition from LIBOR to SOFR. On March 5, 2021, the IBA announced that one week and two month US LIBOR rate quotes will cease at the end of 2021, and that all remaining US LIBOR rate quotes will cease at the end of June, 2023. On the same day, IBA’s regulator (FCA) announced all remaining US LIBOR quotes will either cease publication or will become non-representative at the end of June, 2023 effectively discontinuing LIBOR at that time. This delay will help to ensure a more orderly transition away from LIBOR, but it will not alter our transition efforts.
How is SOFR calculated?
SOFR is a transaction-based rate that represents the cost of borrowing cash (US Dollars) overnight on a secured basis - calculated from three existing transaction-based indices directly related to overnight Treasury repurchase agreements.
How is SOFR different from LIBOR?
There are at least two important differences between the two benchmarks.
First, because LIBOR is an unsecured interbank lending rate, it is often somewhat higher than SOFR, which is considered "risk free." The spread between the two rates often expands when credit markets are under pressure.
A direct switch from LIBOR to SOFR, therefore, is inappropriate, as each rate has different underpinnings. When converting interest rates for existing transactions using a benchmark other than LIBOR, creation of a spread adjustment will be necessary to reflect the historic difference between the two rates. Second, while LIBOR is calculated for multiple forward-looking terms, SOFR is currently only available as an overnight rate. While a forward-looking Term SOFR is being developed that will be based on futures transactions in SOFR, it will be some time before Term SOFR is available. This process may be complicated by the fact that SOFR is potentially volatile at month, quarter and year-end, given its ties to the securities repurchase market. In practice, an average of SOFR may be used to smooth out volatility. In July 2020, the International Swaps and Derivatives Association (ISDA) announced that Bloomberg Index Services Limited (BISL) had begun calculating and publishing fallbacks for derivatives contracts for certain key interbank offered rates, including LIBOR. In addition, ARRC has provided recommended fallback language for US dollar-denominated LIBOR loan products. It may take time for the new benchmarks to become accepted.
On March 5, 2021, following the announcements by the IBA and FCA, ISDA announced that for derivatives the spread adjustment was fixed for all US dollar LIBOR tenors on that date. ARRC has stated that its recommended spread adjustments for non-consumer cash products will be the same as those applicable to fallbacks in ISDA’s documentation.
Is the SOFR benchmark being adopted by other countries around the world?
Each of the five currencies that currently rely on LIBOR is in the process of transitioning to alternative risk-free benchmarks. In the United Kingdom, for example, LIBOR is being replaced by the Reformed Sterling Overnight Index Average (SONIA). Japan has chosen the Tokyo Overnight Average Rate (TONA), the EU has selected the Euro Short-Term Rate (ESTER) and Switzerland has chosen the Swiss Average Rate Overnight (SARON). Adjustments and fallbacks are being developed to create continuity between the benchmarks.
What should businesses do to prepare for the transition?
There are several things businesses can do to begin preparing for the switch from LIBOR to an alternative rate:
Existing transactions – Assess your LIBOR exposure in any current loans, bonds, notes, derivatives and other transactions that mature after June 2023. The documents for LIBOR-based loans, for example, generally include language that allows for certain “fallbacks" in case LIBOR is not available – but these fallbacks may be incomplete or insufficient in the event that LIBOR no longer exists.
Contracts for loans and floating-rate bonds tied to LIBOR, for example, will require changes. Master agreements for international swaps and derivatives will also need to be amended or replaced, either by bilateral amendment or by adherence to the ISDA protocol, as may others. Your banker can be helpful when reviewing the provisions for amending contract terms and conditions.
New transactions – Before completing any new loans or other major transactions between now and the end of 2021, review your standard transaction documents to see if changes are needed to address the benchmark change. Keep abreast of developments in standard LIBOR fallback and replacement language, particularly language proposed by ARRC and ISDA.
For now, several unknowns await clarification. It is not known whether or when Term SOFR will become available. Existing loan and derivatives contracts must be amended and repriced to conform to the new benchmark.
You are likely to have additional questions of your own during this transition period. For answers, your banker is a good place to start or refer to the Alternative Reference Rate Committee's frequently asked questions.