The Fed hopes to move contracts to SOFR, away from the volatile, yet massive LIBOR market.
First Steps
A Libor Replacement Project is underway.
Regulators around the globe began work on replacements for Libor, the London interbank offered rate, well before the U.K.’s Financial Conduct Authority sought to put the beleaguered interest-rate benchmark out of its misery. In the U.S., enter the Secured Overnight Financing Rate, or SOFR, a new reference rate introduced Tuesday by the Federal Reserve Bank of New York in cooperation with the U.S. Treasury Department’s Office of Financial Research. The debut of SOFR is a critical step in a quest to wean more than $350 trillion of securities off Libor.
Why Replace Libor?
For decades, Libor provided a reliable way to determine the cost of everything from student loans and mortgages to complex derivatives. It’s derived from a daily survey of about 20 large banks that estimate how much it would cost to borrow from each other without putting up collateral. Because fewer banks make such unsecured loans, Libor was becoming more theoretical than real. That was vastly compounded by the discovery of rampant manipulation by U.S. and European lenders that were forced to pay billions of dollars to settle rigging and other charges. All this is why the FCA pledged to stop compelling firms to provide estimates by the end of 2021, and why regulators around the world are rushing to establish alternatives.
How is SOFR Different?
Where Libor relied on the expectations of bankers, SOFR is based on real transactions from a swath of firms including broker-dealers, money-market funds, asset managers, insurance companies and pension funds. It’s different from Libor as well in that it’s a secured rate, since the repo rates it’s derived from are collateralized, or backed by assets. It’s an overnight rate, based specifically on overnight loans; Libor, by contrast, covered loan maturities ranging from one day to one year. And the volume of trading underpinning SOFR is significantly larger: In 2017, it regularly exceeded $700 billion daily, versus an estimated $500 million for three-month dollar Libor, according to ARRC data.
