The End of LIBOR and the Emergence of SOFR: A Critical Financial Transition
The End of LIBOR and the Emergence of SOFR: A Critical Financial Transition
London Interbank Offered Rate (LIBOR):
It has nearly a 50-year long history. Each day, 18 international banks submit their ideas of the rates they think they would pay if they had to borrow money from another bank on the interbank lending market in London. It was the average interest rate on transactions that a selection of banks carried out with one another on a daily basis, for each currency and maturity term, and it was regulated by the Financial Conduct Authority (FCA). It was kind of like a benchmark for interest rates. LIBOR reached its final retirement on June 30, 2023.
It’s important to note that Libor isn’t set on what banks actually pay to borrow funds from each other. Instead, it’s based on their submissions related to what they think they would pay. As a result, it’s possible for banks to submit lower rates and manipulate Libor fairly easily.
Secured Overnight Financing Rate (SOFR):
SOFR is another interest rate, but instead of being based on loans between banks like LIBOR, it’s based on loans within the US Federal Reserve System. SOFR is a secured interest rate that uses U.S. Treasury bonds for collateral and eliminates any arbitrary unsecured quotations of interest rates previously provided by banks. Every day, financial institutions borrow money from each other within this system, and SOFR calculates the average interest rate of these loans. It’s kind of like LIBOR in that it’s a benchmark for interest rates, but there are some key differences. One big difference is that SOFR is based on actual observed transactions, not just reported ones, which makes it more reliable. Plus, the amount of money involved in these transactions is huge, usually over a trillion dollars a day, so it’s more representative of the market.
Reason for the need to introduce a new financial standard:
In 2012, it was revealed that banks were rigging the rate. The panel banks that gave LIBOR estimates were collaborating together and submitting false data in order to profit more from trades. Extensive investigations into the way Libor were set uncovered a widespread, long-lasting scheme among multiple banks- including Barclays, Deutsche Bank, Rabobank, UBS and the Royal Bank of Scotland- to manipulate Libor rates for profit.
Key Differences:
The main difference between SOFR and LIBOR is how the rates are produced. While LIBOR was based on panel bank input, SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities in the repurchase agreement (repo)1 market. The transaction volumes underlying SOFR regularly were around $1 trillion in daily volumes. The repo market’s large transaction volume gave the Alternative Reference Rate Committee (ARRC) confidence that SOFR was reliable through a wide range of market conditions, making it a good long-term option to replace LIBOR. The SOFR is based on data from observable transactions rather than on estimated (or falsified) borrowing rates, as was generally the case with LIBOR.
1 A repo is like a short-term loan where one party sells an asset to another with an agreement to buy it back later at a different price. If the seller can’t buy it back, the buyer can sell the asset to recover their money. The asset acts as security, reducing the risk for the buyer. Even though the asset is sold initially, it’s more like a temporary exchange, with the seller getting cash and the buyer getting temporary ownership of the asset. The difference in prices determines the buyer’s return, called the repo rate, which is essentially the interest on the loan.
Other alternative financial standards:
Other countries have sought alternatives to the LIBOR. For instance, the United Kingdom chose the Sterling Overnight Index Average (SONIA), an overnight lending rate, as its benchmark for sterling-based contracts going forward. The European Central Bank (ECB), on the other hand, opted to use the Euro Overnight Index Average (EONIA), which is based on unsecured overnight loans, while Japan applied its own rate, called the Tokyo overnight average rate (TONAR).
References:
- https://www.capitalone.com/commercial/solutions/libor-sofr/
- https://www.caixabankresearch.com/en/economics-markets/financial- markets/libor-sofr
- https://www.srsacquiom.com/our-insights/sofr-vs-libor/
- https://www.exigent-group.com/blog/libor-vs-sofr/
- https://www.jpmorgan.com/insights/markets/libor/the-global-move-away- from-LIBOR
- https://www.investopedia.com/secured-overnight-financing-rate-sofr- 4683954
- https://www.commercebank.com/media/cb/pdf/business/financing/index-comparison-libor-vs- sofr.pdf?revision=a69407a6-0645-4350-a1f9-2af4fe7fa34b&modified=20220209125522
- https://www.forbes.com/advisor/investing/what-is-libor/
- https://www.icmagroup.org/market-practice-and-regulatory-policy/repo- and-collateral-markets/icma-ercc-publications/frequently-asked-questions- on-repo/1-what-is-a-repo/