The transition away from LIBOR

The transition from the London Interbank Offered Rate (LIBOR) to alternative interest rate benchmarks is well underway, but much work lies ahead in order to implement a successful reference rate change by the end of 2021. At this time, markets will no longer have certainty of LIBOR publication.

In this primer from SIFMA Insights, we provide an overview of the LIBOR transition, with a focus on the proposed U.S. alternative reference rate, Secured Overnight Financing Rate (SOFR).

Highlights from the primer include:

• What Is LIBOR? LIBOR is the most commonly used benchmark for short-term interest rates, often referenced globally in derivative, bond and loan documentation.
• Why Is LIBOR Important? It is estimated $200 trillion of financial contracts and securities are tied to USD LIBOR and that matters to everyone – small businesses, corporations, banks, broker dealers, consumers and investors.
• Why Transition Away from LIBOR? LIBOR is based on relatively few transactions – the most active tenor (three months) posts less than $1 billion transactions per day – and relies heavily on expert judgement in determining the rate. The scarcity of underlying transactions makes LIBOR potentially unsustainable, as banks may eventually choose to stop submitting altogether.
• What Is The Role of The ARRC? In the U.S. in 2014, the Fed & New York Fed established the Alternative Reference Rates Committee (ARRC) to lead the transition away from LIBOR. The ARRC continues to lead the transition from LIBOR to SOFR – as well as encourage the development of the SOFR futures market – and its Paced Transition Plan for a smooth transition away from LIBOR is ahead of schedule.
• What Is SOFR? The ARRC selected SOFR as the recommended alternative reference rate for the U.S. While LIBOR is not fully transaction based, SOFR is based on the overnight repo markets with ~ $1 trillion of transactions per day. Publication of the SOFR rate began in April 2018. Trading and clearing of SOFR-based swaps and futures began in May 2018.
• How Is SOFR Calculated? SOFR is calculated as a volume-weighted median of transaction level tri-party repo data, GCF Repo transaction data & data on bilateral Treasury repo transactions cleared through FICC’s DVP service (from DTCC Solutions). SOFR is published each business day on the New York Fed’s website.
• How Is Market Uptake of SOFR? As of June 2019, 27 institutions have issued more than $136 billion notional in floating rate securities tied to SOFR, with a record $24 billion in June. Outstanding SOFR-linked notional across all products has grown from less $100 billion in May 2018 to over $9 trillion as of April 2019, >9,000%. The jump in February 2019, +35% month/month, implies increased interest and involvement from market participants.
• How Does SOFR Differ from LIBOR?

SOFR	LIBOR
Risk free rate (no credit risk)	Bank lending rate (includes credit risk)
Overnight (backward looking)	Forward looking
Secured (collateralized)	Unsecured (uncollateralized)
Calculated & published daily by the NY Fed	Calculated & published daily by ICE Benchmark Administration
Transaction based	Based on LIBOR bank submissions & expert judgement
Based on ~$1T transactions pd (repo markets)	Based on ~$1B transactions pd (3-month LIBOR)
No term structure	Term structure

• The Path to Building a Strong Futures Market. The smooth transition to SOFR is dependent upon the development of strong SOFR futures (and swaps) markets; a strong futures (and swaps) market is also necessary to build a SOFR term structure. In this section, we analyze the growth of the SOFR futures markets using CME product data, comparing SOFR to other contracts volume growth trajectories.
• IBOR Global Benchmark Transition Checklist. Assess exposures to IBORs; comprehend how a permanent cessation of IBORs impact you and your clients; mobilize a formal IBOR transition program; define a transition road map; and develop an external communication strategy.
• Global Efforts to Transition to New Reference Rates. The Financial Stability Board (FSB) aims to ensure transition plans are consistent and coordinated and interest rate benchmarks are robust and appropriately used by market participants. We highlight key work being performed across the globe.

SIFMA Insights Primers

The primer series from SIFMA Insights goes beyond a typical 101-level brief, breaking down important technical and regulatory nuances to foster a fundamental understanding of the marketplace and set the scene to address complex issues arising in today’s markets.

See our full series here.

Author

Katie Kolchin, CFA
Senior Industry Analyst
SIFMA Insights