Sofr Rate vs Libor: Understanding the Shift

The shift from Libor to SOFR has been a significant change in the financial industry. The Secured Overnight Financing Rate (SOFR) is now the primary benchmark for short-term interest rates in the US.

SOFR is calculated based on transactions in the US Treasury repurchase agreement market, making it a more transparent and reliable benchmark than Libor. This is a key difference between the two rates.

As a result of this shift, many financial institutions and companies are re-examining their contracts and agreements to ensure they are compliant with the new benchmark. This is a complex process that requires careful attention to detail.

The SOFR rate is already having a significant impact on the financial markets, with many expecting it to become the new standard for interest rate swaps and other financial instruments.

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Sofr is the rate at which banks borrow and lend U.S. dollars overnight in the federal funds market. It's a key benchmark for short-term interest rates in the United States.

The Sofr rate is named after the Secure and Fair Enforcement for Mortgage Licensing (SOFARate) Act, which was passed in 2008 to improve transparency in the mortgage market.

The Sofr rate is calculated by the Federal Reserve Bank of New York, which collects data from a large sample of trades in the federal funds market.

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LIBOR was originally based on interbank lending transactions, but due to changes in how banks fund themselves the underlying bank-to-bank lending market has shrunk significantly.

This lack of underlying transactions led to an increase in fraud and manipulation, also known as LIBOR rigging scandals, due to the panel banks' own judgment being used to determine quotes.

The UK Financial Conduct Authority announced it would no longer compel panel banks to submit LIBOR quotes after 2021, which may cause banks to no longer provide quotes given the associated risks and liabilities.

The IBA's website states that there is no guarantee that any LIBOR settings will continue to be published after year-end 2021, making it essential for users to develop transition or fall back plans.

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LIBOR was originally based on interbank lending transactions, but due to changes in how banks fund themselves the underlying bank-to-bank lending market has shrunk significantly.

With few actual transactions for banks to base their quotes on, LIBOR submissions became dependent on the panel banks' own judgement, leading to an increase in fraud and manipulation.

The UK Financial Conduct Authority announced in July 2017 that it would no longer compel panel banks to submit LIBOR quotes after 2021.

Regulators globally have been investigating alternative risk-free rates (RFR) based on a larger pool of underlying transactions.

As of now, there's no guarantee that any LIBOR settings will continue to be published after year-end 2021.

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The Federal Home Loan Bank System is a key player in the transition away from LIBOR, with over $316 billion in outstanding floating-rate notes, making it the second-largest issuer after the U.S. Treasury.

As an early advisor to the Alternative Reference Rates Committee (ARRC) in 2016, the FHLB System has been actively involved in the development of the SOFR index.

The FHLB System is the #1 issuer of SOFR bonds, with over $118 billion issued as of August 2019.

Randall Quarles, Vice-Chair for Supervision at the Board of Governors of the Federal Reserve System, has warned that LIBOR could become unstable, and it's hard to see how one could be clearer than that.

The FHLB System has already converted a third of its floating-rate debt to SOFR, shifting from 99% LIBOR to 33% SOFR/66% LIBOR in just nine months.

Randy Snook, CEO of the Federal Home Loan Banks' Office of Finance, noted that the FHLBanks provide access to reliable liquidity to approximately 6,800 members in support of housing finance and community investment.

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SOFR and LIBOR differ in their underlying market dynamics. LIBOR is a daily average of what banks say they would have to pay to borrow for another bank, while SOFR is a secured, overnight rate based on actual transactions collateralized by Treasurys.

LIBOR is forward-looking, providing borrowers with the interest rate for a given period at the beginning, whereas SOFR is backward-looking, with the interest rate determined after the period. This difference affects how borrowers and lenders know their interest payments.

A significant challenge in transitioning from LIBOR to SOFR is the lack of a large, developed derivatives market for forward term SOFR. This means that borrowers and lenders will not know a given interest payment until the end of each interest period. The UK Financial Conduct Authority announced that LIBOR would no longer be representative for certain terms, triggering the fixation of ISDA fallback spreads for existing securities.

SOFR is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities in the overnight Treasury repurchase agreement market.

The cost of borrowing cash overnight is typically measured in the overnight Treasury repurchase agreement market, which is where SOFR originates.

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Term SOFR is published in one-, three-, six- and 12-month forward-looking rates, making it a useful tool for financial planning.

These forward-looking rates are a key feature of Term SOFR, allowing users to plan for the future with more accuracy.

J.P. Morgan's preferred rate is Term SOFR, but other variations of SOFR are also available for those who need them.

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LIBOR is a daily average of what banks say they would have to pay to borrow for another bank for various terms, and it includes a credit risk premium.

The rate is forward-looking, so borrowers know the interest rate for a given interest period at the beginning of the period. However, this bank-to-bank lending is unsecured.

SOFR, on the other hand, is a secured, overnight, risk-free rate based on actual transactions collateralized by Treasurys.

Key differences between LIBOR and SOFR include:

The lack of a large, developed derivatives market for forward term SOFR is a significant challenge in transitioning from LIBOR to SOFR.

The transition from Libor to SOFR is likely to have a significant impact on markets and lending.

Historically, during downturns and market disruptions, SOFR has tightened while credit-sensitive rates like Libor have widened.

The spread differential between SOFR and Libor has remained within 5 to 30 basis points about 70% of the time over the past two decades.

However, during periods of market stress, this differential has reached 100 basis points or more about 6% of the time, including during the global financial crisis.

This difference in loan economics could change the way loan investors approach lending, as they may not see the same level of widening on the base rate for SOFR as they would for Libor.

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The LIBOR-to-SOFR transition is a complex process that will have far-reaching implications for the financial industry. The transition away from LIBOR could be challenging, as SOFR differs from LIBOR in key ways, such as being an overnight rate versus a forward-looking benchmark.

Operational issues will be a major challenge, as financial institutions will need to adjust their systems and ensure their vendors are upgraded. This will involve handling compounded and simple average calculations, shifts, lookbacks, and other convention components.

The industry has been anticipating this switch for years, but now lenders will need to reach out to their borrowers, who may be struggling with the broader macroeconomic environment. Any move to renegotiate a contract may be seen skeptically.

There is currently a lack of clarity on how to calculate interest once LIBOR has been replaced by SOFR, with different approaches being proposed, such as a "lockout" or a "lookback". This uncertainty may lead to misalignments between lenders and borrowers.

To mitigate these risks, lenders will need to adapt pricing strategies for risk-free rate lending, such as using non-zero floors to minimize risks and manage their balance sheet. This will require identifying new pricing strategies, modeling their impact on the portfolio, and negotiating terms with counterparties.

Here are some key areas for loan investors to watch during the transition:

In summary, the LIBOR-to-SOFR transition will require significant operational changes and a new approach to pricing and risk management. Lenders will need to be proactive in adapting to these changes and communicating with their clients to ensure a smooth transition.

The transition to a new benchmark rate is a massive undertaking, with J.P. Morgan undertaking major legal, operations, systems, and communications work to ensure a smooth path.

The LIBOR Transition is the biggest transformation in financial services today, affecting some $200 trillion of U.S. Dollar transactions. This is a staggering figure, and it's clear that the transition needs to begin today.

The Federal Home Loan Bank System is playing a crucial role in developing a new market, and the Federal Home Loan Bank of New York is providing alternative floating-rate funding. This is a vital step in ensuring a smooth transition.

The transition is not just about replacing LIBOR with a new rate, but also about preparing for multiple SOFR conventions. Different conventions, such as simple averaging, compound averaging, and calculated with lags, shifts, and lockouts, may be used for different contracts.

The Alternative Reference Rates Committee (ARRC) has developed a SOFR Starter Kit to help with the transition. This kit includes key facts about SOFR, such as its history and background.

The transition deadline is looming, with LIBOR slated for cessation at the end of 2021. The FHLBanks' ability to enter into LIBOR-based instruments that mature after December 31, 2021, has been extended to June 30, 2020, except for investments and option embedded products.

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The LIBOR cessation is still in flux, but progress towards a consensus is being made.

Regulators are paying close attention to any potential value transferal between parties due to the transition.

ISDA's amended fallback definitions for both new trades and legacy trades will provide great clarity and direction to borrowers.

A LIBOR hedge today will not suddenly be worthless when LIBOR is discontinued, as intense focus is on making any replacement RFR economically neutral to current LIBOR.

For now, it's worth discussing the Hedged Loan Approach regarding replacement language in new financings.

Once lenders review and get comfortable with the details of ISDA's calculation methodology for the SOFR fallback, they are more likely to encourage adoption on the loan side.

The overall impact on your financing cost should be minimal if lenders start adopting the Hedged Loan Approach.

We can expect a further bump in SOFR activity following ISDA's release of their amended 2006 Definitions.