Published on May 21, 2019 by Suren Weerasekera
The markets expect the Secured Overnight Financing Rate (SOFR), a well-positioned, new benchmark reference rate, to replace the three-decades-old, scandal-plagued London Interbank Offered Rate (LIBOR) in 2021. It is widely believed that the transition will be challenging given the widespread use, scale, and scope of LIBOR, as LIBOR has been established as the international standard for everything from consumer loans to USD190tn worth of interest-rate derivatives.
Why LIBOR has Failed
Regulatory bodies and market participants have had compelling reasons to phase out LIBOR and adopt a better and more sustainable alternative. LIBOR’s major drawback is the scarcity of underlying transactions. The reference rate has USD500m or less in underlying daily transactions that feed into it for nearly USD200tn of derivatives, loans, securities, and mortgages.
Following the 2008 financial crisis, unsecured borrowing transactions between banks dropped significantly, narrowing the size of the underlying market that fed into LIBOR. Regulatory bodies have also caught major global banks fraudulently maneuvering LIBOR, both upwards and downwards, based on their traders’ positions, to earn undue profits. Since the financial crisis, global banks have collectively paid over USD9bn in fines for manipulating LIBOR, denting public trust in the benchmark reference rate. Therefore, the Alternative Reference Rates Committee (ARRC) recommended the SOFR in 2017 as an alternative to USD LIBOR.
Shortly after this recommendation, the Financial Conduct Authority (FCA) announced the discontinuation of LIBOR in 2021.
SOFR and its Impact
The SOFR is a secured reference rate overseen by the New York Fed and largely measures the cost of borrowing money overnight, with US Treasuries as collateral. In contrast to LIBOR, underlying daily transactions worth over USD750bn feed into the SOFR, implying that this market is larger than any other US money market. The ARRC recommended the SOFR primarily because it is based completely on transactions and reflects the cost of secured borrowing across a wide array of market participants not limited to the interbank market. These key characteristics make the SOFR less prone to scandals and more durable.
As the SOFR is an overnight rate, it is essential to model a term structure (yield curve), for both accounting and operational reasons. As part of the transition plan, the ARRC is developing a forward-looking term structure and intends to establish it using derivatives. CME Group launched SOFR futures in May 2018, and this market has since grown to over USD2.9tn. Although it is still in a nascent stage, firms have collectively issued over USD41bn of SOFR floating-rate notes to date.
The transition to the SOFR will likely impact market participants’ profitability given that they would have to revise their valuation and pricing strategies due to the change in the reference rate; consequently, gains from investing and the cost of debt would change. The transition will likely be complex, as the SOFR would have to be adopted across the full range of financial products, and firms would have to coordinate with thousands of customers and vendors who may not have similar schedules.
Firms could mitigate risks stemming from the transition by remodeling their business functions effectively – from strategy and financial management to accounting and contract management. Regulatory bodies and firms are also likely to face significant challenges when changing existing LIBOR contracts, as several of these were probably drafted assuming that any disruption to LIBOR would be temporary. Legal language used also varies by product type. The authorities, therefore, recommend that all new contracts be drafted using the SOFR, to reduce LIBOR exposure, and that new contracts tied to LIBOR include robust contingency plans.
How Acuity Knowledge Partners can help
We can help financial institutions achieve a smooth transition and avoid a large, negative impact on their margins by identifying contracts tied to LIBOR and updating the contract terms to incorporate the SOFR using technologies such as optical character recognition (OCR). We could also digitize contracts using OCR technology, making client onboarding, contracting, and negotiation more efficient. Our solutions extend to restructuring repayment schedules using the SOFR, promoting flexibility, innovation, and efficiency across business units.
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About the Author
Suren currently supervises an engagement for a leading Europe-based multinational banking and financial services corporation in covenant monitoring and credit rating process. Previously worked as an offshore analyst for a leading US-based multinational financial services firm and provided support in equity valuation, financial analysis, and financial modeling.
Suren holds a Bachelor of Business Studies (Accounting and Finance) from Massey University, New Zealand. He is also an ACCA UK member.
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