The London Interbank Offered Rate, often known as LIBOR, has been around for about half a century, representing$200 trillion worth of financial instruments and contracts. However, due to alterations in the rate's transparency and dependability, industry specialists have begun to explore alternatives. This implies that LIBOR is frequently relied on the judgment of a panel of banks, as opposed to reliable market data, which undermines its credibility.

As a consequence of this, the market is progressively relying on the Secured Overnight Financing Rate (SOFR) as a replacement for the LIBOR, which is scheduled to be totally eliminated by the end of 2021.

This article will examine the key differences between the SOFR and the LIBOR, as well as the necessary changes for companies with LIBOR-referenced contracts.

LIBOR, the Definition

The London Interbank Offered Rate (LIBOR) is a standard rate that is applied in the computation of interest for many different types of financial contracts. Since the 1970s, it has been put to use all over the world in many contexts, including commercial loans, derivatives, transactions involving small businesses, and even certain consumer products, such as student loans.

Nevertheless, in 2012, it was discovered that banks were manipulating the rate – An inquiry revealed that some banks that provided LIBOR estimates colluded and submitted fraudulent data to increase their profits from trades. The underlying market that sets LIBOR has lost considerable trade volume over time.

2021 marked the start of LIBOR's demise – U.S. federal and state financial authorities reaffirmed their anticipation that regulated banks with LIBOR activities will move toward an orderly transition away from the benchmark. As a result, institutions were encouraged to stop using USD LIBOR as a benchmark rate for new contracts after the end of 2021.

LIBOR will be retired for good on June 30, 2023. As markets, regulators, and businesses adjust to life after LIBOR and the numerous transition deadlines, it is crucial for firms to comprehend how they may be impacted.

This news prompted financial regulators throughout the world to initiate the development of alternatives to LIBOR – Alternative Reference Rates Committee (ARRC) formulated SOFR.

In contrast to LIBOR, the basis for determining SOFR is actual transactions. Since these transactions are public, they are less susceptible to manipulation, which makes this technique of determining the cost of borrowing money a more exact approach.

SOFR, the Definition

Secured Overnight Financing Rate (SOFR) is a standard measure of the cost of overnight Treasury-backed borrowing. The rate is determined by transactions on the Treasury repo (repurchase) market, where investors provide banks (overnight) loans secured with their bond holdings. In the trade of derivatives, benchmark rates such as SOFR are crucial.

SOFR, in contrast to LIBOR, makes use of actual borrowing costs incurred by banks rather than the unreliable predictions of a panel of banks. However, it is worth noting that the possibility of tampering still exists – Banks have the ability to borrow and lend money at skewed interest rates on the wholesale financing market, which can lead to gains on the much larger market for benchmark-indexed contracts. As a result, a suggestion was made that the interest rates that individual banks charge for loans should be made public in order to encourage openness and deter manipulation.

Adjustments to credit spreads are an aspect of SOFR that should be thoroughly comprehended. Because the methodology behind LIBOR and SOFR are distinct from one another, it is possible that the published rates of the benchmarks will not be identical. As the shift takes place, the institutions involved may consider making modifications to the credit spread in an effort to bring the secured SOFR rates closer to the unsecured LIBOR rates.

Upcoming Transition Challenges

The transition is challenging in nature due to the billions of dollars in ongoing LIBOR contracts, some of which will not expire until the benchmark is abolished. This includes the common 3-month USD LIBOR, which encompass nearly $200 trillion in financial instruments.

There are significant discrepancies between both rates, making contract revaluation difficult. For instance, LIBOR covers unsecured loans, but SOFR, which represents loans secured by Treasury bonds, is a rate that is almost risk-free. In addition, LIBOR contains 35 distinct rates, whereas SOFR only releases a single rate.

Figure 1: LIBOR vs. SOFR. Source: Strategic Finance

In 2018, EY identified two possible contract renegotiation difficulties. First, these loan and derivative contracts are available in electronic format in many businesses, allowing for their analysis. However, some contracts may only be available in hard copy, necessitating additional time for analysis; so, it is imperative to begin the review process as soon as feasible. The second obstacle is the probable unwillingness of the contractual parties to reach an agreement. Other parties to the deal may reject renegotiation of the contract's terms, thus stressing the necessity to begin immediately.

As previously stated, it is anticipated that the transition to SOFR would have a significant influence on the market for derivatives. It is also anticipated that it will have a substantial impact on products connected to consumers, such as mortgages with variable interest rates, as well as debt products.

The Bottom Line

Because renegotiations of contracts can be difficult and time-consuming, firms should begin the process as soon as it is practically possible to do so. It is especially suggested that companies be aware of significant upcoming dates, LIBOR terms in loan agreements, and SOFR characteristics. Additionally, it is suggested that companies ensure that their internal systems and procedures are equipped to meet the new alternative rates.

In conclusion, businesses may successfully gear up for the end of LIBOR and make the required shift if they approach their preparations with caution.

Get Trade Ideas, Live Class, Expert Support & Community Access​

Masters in Trading Community

Masters in Trading Community is our monthly membership that provides you with the trades that matter. Get trades delivered weekly, find the support you need from a live Q&A session and rely on the guidance and support of a vibrant and exclusive Discord community.