America's Libor Replacement Is Taking Its First Steps: QuickTake

(Bloomberg) -- 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.

1. Why the push to 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.

2. How did the U.S. come up with SOFR?

To develop and implement a replacement for the dollar-denominated version of Libor, the Federal Reserve in 2014 set up the Alternative Reference Rates Committee (ARRC), which brought together representatives from the private sector and regulators. By May 2016, the committee had narrowed the search to two options: the New York Fed’s overnight bank funding rate, and a rate based on repurchase agreements, which are transactions for overnight loans collateralized by Treasury securities. After a series of roundtable discussions, and with feedback from advisory groups, the committee identified the latter -- SOFR -- as the best candidate.

3. How does it differ from Libor?

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.

4. What comes next?

The ARRC is instituting a six-step plan that includes the creation of various derivatives based on SOFR. Along those lines, CME Group Inc. plans to launch monthly and quarterly SOFR futures on May 7, pending regulatory review. Development of a derivatives market is critical, because without a deep and liquid one, regulators won’t be able to create longer-term SOFR-based reference rates, a key goal in expanding usage among market participants.

5. Is the market ready to dump Libor for SOFR?

So far there’s been a degree of complacency in reducing long-term exposures to Libor, according to NatWest strategist Blake Gwinn. ARRC has established working groups in order to get credit-based market participants to adopt fallback language in contracts for products such as loans and mortgages in the event Libor stops being reported. That’s a first step toward the eventual goal of getting firms to make SOFR their benchmark of choice.

The Reference Shelf

©2018 Bloomberg L.P.