Life after LIBOR: a new path for reference rates

The London Interbank Offered Rate (LIBOR) originated in 1969 when a Greek banker named Minos Zombanakis persuaded a syndicate of London banks to lend $80 million to Iran. None of the banks was comfortable making the entire loan itself, but together, calculating the interest rate on the weighted average of the banks’ funding costs, rounded up to the nearest eighth and with a spread added, the banks agreed to the deal.¹ Zombanakis coined the term LIBOR. Other major currencies for which LIBOR was eventually quoted include the British pound, Japanese yen, Swiss franc, and euro.

Over the following decades, LIBOR became essential to billions and then trillions of dollars of financial contracts, including fixed versus floating interest-rate swaps, with the floating portion based on LIBOR plus a spread. But the rate was based on the question, “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11:00 a.m.?”² Intrinsic to this question were at least two problematic issues: Could the bank, in fact, borrow at such a rate since it wasn’t required to show any transaction, and what constituted a “reasonable market size?” Banks would have a natural incentive to quote lower funding rates than they could realistically achieve to enhance their standing—and possibly their profits—depending on the nature of their positions. 

Following the 2008 global financial crisis, interbank funding became increasingly unpopular because of new capital and liquidity rules. LIBOR had essentially become a fiction, involving only hundreds of millions of dollars in underlying transactions while serving as the calculation basis for trades potentially representing $400 trillion or more.³

Finding a reference rate based on truer and greater liquidity would therefore be a favorable development. While there had long been suspicions of misrepresentation, a full-blown scandal hit LIBOR in 2012, when several banks were penalized with large fines and top executives were forced to resign. 

The U.S. Federal Reserve formed an Alternative Reference Rate Committee (ARRC) in 2014. The ARRC settled on a new rate, the Secured Overnight Financing Rate (SOFR), which would underlie U.S. dollar-denominated trading based on secured overnight transactions involving U.S. Treasury repurchase agreements. Since its inception, as discussed, LIBOR has been based on estimations. By contrast, SOFR is measurable and secured since the overnight loans are collateralized by Treasuries. It would be a volume-weighted (based on the median trade) rate, and because of the Treasury collateral, it would be essentially risk free, unlike LIBOR, which is unsecured and relies on the credit of the lending bank.

As of July 2019, the overnight repo volume was about $1 trillion.⁴ According to the Federal Reserve Bank of New York, three-month LIBOR volumes are closer to $500 million daily.⁵ Also unlike LIBOR, SOFR is overnight and backward-looking, as it’s based on transactions that have already taken place, whereas LIBOR has maturities ranging from 1 day to 12 months.

The overnight nature of SOFR lends itself to more volatility than longer-dated instruments. Also, developing and expanding SOFR futures markets is one of the key challenges in the transition. In order to develop the market, the Chicago Mercantile Exchange (CME) began listing one-month and three-month SOFR futures contracts in May 2018.⁶  Liquidity in these contracts should help generate forward curves that will in turn be essential for hedging and pricing.

The United Kingdom’s regulatory body, the Financial Conduct Authority (FCA) drew a line in the sand for the end of 2021, saying it would no longer request or expect banks to submit LIBOR quotes at the end of that year. An FCA spokesman said in July 2020 that the “four to six months ahead of us are arguably the most critical period in the transition away from LIBOR.”⁷

Major international currencies are moving toward the following alternative reference rates: GBP LIBOR will be replaced by Sterling Overnight Indexed Average (SONIA); EUR LIBOR and Euro Overnight Index Average (EONIA) will be replaced by Euro Short-Term Rate (ESTR); JPY LIBOR will be replaced by Tokyo Overnight Average Rate (TONA); and CHF LIBOR will be replaced by Swiss Average Rate Overnight (SARON). SARON will be the only new secured, repo-based rate other than SOFR. Some consider unsecured rates more attractive because they make the transition from unsecured LIBOR easier, while others prefer a purer risk-free rate.

Although it doesn’t relate directly to LIBOR, an important event took place over 2020's October 17–October 18 weekend. The two clearinghouses for interest-rate swaps, London Clearing House and CME, transitioned discounting on USD-discounted products from federal funds to SOFR. The purpose was largely to encourage more SOFR liquidity.

Participants received cash payments representing the difference in swap valuation and a basis swap protecting them from having forward exposure to a different rate. Participants were also given the option of unwinding their basis swaps in an auction to be held that weekend. Participants who opted out of the auction could either hold their swaps to maturity or sell them in the regular course of business.

Because of the aggregate size of transactions involving LIBOR—not only swaps, bonds, options, and the like but also arrangements with custodians, transfer agents, and data vendors—there’s a substantial amount of work to be done in preparation for a switch from LIBOR-based contracts to ones involving SOFR or the international equivalents. Financial firms will likely talk about dedicated internal working groups and ongoing discussions with regulators.

In particular, these communications will discuss how some contracts already have “fallback language” that dictates how payments will be adjusted in a post-LIBOR regime. Contracts that don’t have this feature will rely on negotiations between counterparties. Firms will also likely express caution about entering new transactions involving LIBOR. For existing contracts, if neither LIBOR nor an acceptable substitute is applied to a contract beyond 2021, the final LIBOR rate might be used, therefore changing a floating-rate obligation to a fixed-rate one.

It would be impossible to cover the effects and calculation complexities on the universe of financial products of the LIBOR transition without a much longer discussion. But to offer a preview of what’s next, we offer several examples for consideration.

• Fannie Mae began quoting on September 1 multifamily SOFR adjustable-rate mortgages and indicated that on October 1 it was planning to begin accepting delivery of them. Fannie Mae will no longer acquire multifamily ARM loans after the end of 2020.⁸
• The ARRC published on June 30, 2020, updated (from April 2019) hardwired fallback language allowing “the use of a simple daily SOFR in arrears … for parties to syndicated loans to switch over to an alternative reference rate such as SOFR before the hard end-of-2021 deadline.”⁹
• For derivatives, ISDA in July 2020 published indicative Bloomberg fallback rates to address the risk of the discontinuation of a reference rate.¹⁰
• There’s evidence that floating-rate notes tied to LIBOR can be renegotiated despite challenges in the absence of fallback language. Thought to be the first switcher, Associated British Ports was able in 2019 to get noteholders to agree to change the benchmark from LIBOR to SONIA.¹¹ While this is promising, we anticipate there will likely be cases where issuers and noteholders reaching agreement will be protracted and difficult.
• For new issues, “for pricing of bank, GSE, asset-backed securities (ABS) and other floating-rate notes this means that rather than pricing at … LIBOR plus a spread, pricing would likely be SOFR plus a modestly wider spread to equal the same assumed yield during period one.”¹²

In short, the switch from LIBOR to alternative reference rates will require a large amount of ad hoc work on individual situations. While it is unclear how the relationship between LIBOR and other rates will ultimately play out for certain, fortunately the industry recognizes the challenges and is committing substantial resources to address them.

1 bloomberg.com, November 29, 2016. 2 Federal Reserve Bank Staff Report #667, March 2014. 3 BIS Quarterly Review, March 2019. Since most of this amount is derivatives, the number may appear overstated. 4 sifma.org, July 15, 2019. 5 The New York Fed, writing in medium.com, November 26, 2018. 6 federalreserve.gov. 7 “Libor Troubles Deepen as Deadline for Benchmark’s Demise Approaches,” The Wall Street Journal, August 14, 2020. 8 capmrkt.fanniemae.com. 9 clsbluesky.law.columbia.edu. Discussion with attorneys from Paul Weiss. 10 isda.org. 11 cws-lawnow.com, June 2019. 12 “Are treasury or banks the next big issuer of SOFR floaters?” bloomberg.com, November 19, 2019.