America’s Libor Successor Is Racing to Gain Traction: QuickTake
(Bloomberg) -- Efforts by global regulators to develop a replacement for scandal-tainted Libor, the London interbank offered rate, are well underway. In the U.S., the Federal Reserve Bank of New York and U.S. Treasury Department’s Office of Financial Research introduced the Secured Overnight Financing Rate, or SOFR, in April. The development of the reference rate and derivatives markets tied to it are a critical step in the quest to wean more than $350 trillion of securities off Libor.
1. How is SOFR performing so far?
The benchmark has come a long way since April, when two weeks after its introduction the New York Fed disclosed it had made errors calculating the rate. Since the initial hiccups, SOFR has largely printed in line with expectations, close to the effective fed funds rate, the Fed’s target benchmark. One concern is that it has proven more volatile than Libor, given that it’s more susceptible to price swings tied to Treasury-bill issuance, as well as month- and quarter-end supply variations.
2. Is the market ready to dump Libor for SOFR?
Not quite. While trading in futures tied to SOFR has steadily increased since their debut in May, volumes and open interest remain well below alternative interest-rate contracts such as fed funds futures. Larger volumes of trades are needed in order to develop longer-term SOFR-based reference rates, a key goal in expanding usage among market participants.
3. Is there a rush?
Sort of. Libor is supposed to be phased out by the end of 2021. If SOFR isn’t a viable successor by then, markets may insist on sticking with Libor despite the best efforts of regulators.
4. What’s the next step?
The Alternative Reference Rates Committee (ARRC), the entity tasked with developing and implementing Libor’s U.S. replacement, has been following a six-step SOFR transition plan. Now that derivatives trading has begun, ARRC Chair Sandra O’Connor said the committee can work next on establishing an indicative term structure. Separately, the committee has released proposed fallback contract language for dollar-Libor floating-rate notes and syndicated business loans. This should help ensure that new contracts that reference Libor continue to be effective if and when it’s no longer viable.
5. 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 U.K.’s Financial Conduct Authority pledged to stop compelling firms to provide estimates by the end of 2021, and why regulators around the world are rushing to establish alternatives.
6. 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 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.
7. 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: This year, it’s averaged about $779 billion daily since the benchmark’s launch, New York Fed data show, versus an estimated $500 million for three-month dollar Libor.
8. What have other countries done?
In Europe, the banks have opted for Ester, the euro short-term rate, which reflects wholesale unsecured overnight borrowings costs. The European Central Bank plans to start producing the rate no later than October 2019. The Swiss have turned to Saron, as the Swiss Average Rate Overnight is known, which is also pegged to repo rates. The U.K. has selected Sonia, an alternative derivatives reference rate that reflects bank and building societies’ overnight funding rates in the sterling unsecured market. And in Japan, it’s the unsecured Tokyo Overnight Average, or TONA, administered by the bank of Japan and based on money-market rates.
The Reference Shelf
©2018 Bloomberg L.P.