The London Interbank Offered Rate (LIBOR) has had a good run; not every financial standard can claim a nearly 50 year history. But by the end of 2021, the benchmark rate is being retired — and for some very good reasons.
Of the $250 trillion worth of financial contracts that are tied to LIBOR, those contracts denominated in US dollars will transition to the Secured Overnight Financing Rate, or SOFR.
What’s the main difference between LIBOR vs. SOFR? How should organizations with LIBOR-referencing contracts adjust? Before we dive into answering these questions, let’s take a look at the characteristics of the two rates.
LIBOR: Why is it being retired?
LIBOR is calculated from estimates of the rate that major London banks charge each other for loans. For historical reasons, the rate has become widely adopted throughout the financial industry and is used to price derivatives, cash products and other financial instruments.
In 2012, however, 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.
Furthermore, the transactions that LIBOR was supposed to be based on — interbank loans — weren’t really taking place. Instead, panel banks estimated the rate they would hypothetically lend to one another, adding an element of uncertainty to the estimates even if they are made in good faith.
In consideration of all of these factors, the Financial Conduct Authority (FCA) announced in 2017 that it would phase out the benchmark by the end of 2021.
Out with the old, in with the new
This announcement spurred financial authorities across the world to get started on crafting alternative benchmark rates to replace LIBOR. For dollar-denominated contracts, the Alternative Reference Rates Committee (ARRC) crafted SOFR.
Unlike LIBOR, SOFR is based on actual transactions — namely, overnight transactions in the Treasury repo market. Thus, SOFR is a more accurate means of measuring the cost of borrowing money. Because these transactions can be observed by anybody, it’s also less easily manipulated.
LIBOR vs. SOFR
In theory, transitioning from the use of LIBOR to SOFR in contracts should be simple: The old rate wasn’t based on real transactions and was subject to manipulation, so we’ll use the new rate that is based on real transactions and therefore can’t be easily manipulated.
Unfortunately, it isn’t that simple.
One of the advantages of LIBOR is that its estimates could be made for seven borrowing periods ranging from a day to 12 months.
In contrast, SOFR only directly accounts for overnight transactions.
Since LIBOR offers these forward-looking term rates while SOFR only looks backward overnight, contracts that switch from a LIBOR term rate to SOFR will need to be adapted.
The ARRC plans to develop a robust forward-looking SOFR term rate that is compliant with the International Organization of Securities Commissions (IOSCO) by the end of 2021. In the meantime, the Federal Reserve has released a note estimating indicative forward-looking term rates and a method for their calculation (though they caution these estimates are for informational purposes only).
Adjusting for a risk-free rate
Because SOFR is based off of overnight Treasury transactions, it’s considered to be a risk-free rate, while LIBOR includes the credit risk of borrowing from a bank.
The majority of LIBOR-referencing contracts have no need to include this credit risk, but they contain it nevertheless. Because of this, contract parties will need to adjust SOFR when using it to replace LIBOR in order to avoid creating winners or losers during the transition.
How do we adapt our contracts for SOFR?
Going forward, all new contracts should simply reference SOFR where they would have referenced LIBOR. For the many LIBOR-referencing contracts that mature past 2021, however, organizations need to make significant changes in order to reduce their risk exposure.
Ideally, these contracts should be renegotiated to reference SOFR, but that won’t be possible in all cases. When they can’t be renegotiated, contracts should be amended to include robust fallback language that clearly lays out how and when the benchmark rate will transition to SOFR.
Obviously, this is no small feat. Not all contracts can be treated similarly, making the LIBOR vs. SOFR transition a massive project that can be challenging to navigate. When faced with highly complicated and scaled projects such as the LIBOR transition, using technology to extend your team is a must. Contract management solutions can assist general counsels in searching for vulnerable contracts and conducting their transition in a thorough and consistent way. Our Data Discovery Tool Scarlett allows you to quickly search across any document set for clauses and key terms like liability, LIBOR, payment terms, etc. And search results are returned instantly. Contact us for a complimentary trial.