LIBOR, known also as The London Interbank Offered Rate, is a baseline interest rate that key players in the global banking landscape use for short-term loans between major banks within the international banking market. However, the LIBOR era of influence is set to end come 2022. Below, we’ll be taking a look at the implications that this conversion may have.
Officials wish to halt the use of LIBOR and fully phase out its use by the end of 2023 due to world economies continuing to grow in both size and complexity. LIBOR rate calculators are completed by panel banks, a group of banks which report their funding rates to the Intercontinental Exchange Benchmark Administration (IBA). The numbers are then averaged, adjusted, and released at approximately 11:45 A.M. London time on business days.
At this point in time, the process is outdated and significant concerns have arose surrounding a large decrease in the sample size of panel banks used to calculate LIBOR. Due to the ramifications of the 2008 financial crisis and its aftermath, this has led to fewer panel banks reporting consistently. Those that do continue to report are reporting fewer transactions than before the 2008 financial crisis.
LIBOR is set to be fully replaced by SOFR (the Secured Overnight Financing Rate) on June 30th, 2023, with the phase-out of LIBORs use beginning in 2022. At this point, all derivatives, dollar-denominated loans, and debt will reference the new SOFR rate which is a median of rates that market participants pay to borrow cash on an overnight basis while using Treasury as collateral.
(Image Source: Pensford LIBOR SOFR Update 2020)
In taking stock and comparing the different factors that comprise LIBOR and SOFR, the conversion is not one-to-one. It’s true that both SOFR and LIBOR are comprised of short-term borrowing costs, but the key differences between them makes this transition tricky to navigate. SOFR relies on transaction data, whereas LIBOR is based partially on market-data in addition to “expert judgment.”
SOFR is a daily rate, and whereas LIBOR is made up of seven varying rates that vary on terms of one day to one year. The last key difference worth noting is that LIBOR has a credit-risk component due to the fact that it represents the average cost of borrowing by a bank. In contrast, SOFR essentially represents a “risk free” rate because it is based on Treasuries.
As for specifics for what’s required of lenders and issuers, both face a technical choice between using a simple or a compound average of SOFR as they seek to use SOFR in cash products. Seeing as many systems are already set up to accommodate using simple interest conversions, this may be the easier approach. However, compounded interest would more accurately reflect the time value of money, which becomes a more important consideration as interest rates continue to rise and it can allow for more accurate hedging and better market functioning.
Treasures are tasked with needing to determine the period of time over which the daily SOFRs are observed and then averaged. With an “in advance” structure, this would reference an average of SOFR observed before the current interest period begins, while an “in arrears” structure references an average of SOFR over the current interest period.
An average of SOFR in arrears will reflect what actually happens to interest rates over the set period of time; however, it consequently provides very little notice before payment is due. There have been a number of conventions designed to allow for a longer notice of payment within the in arrears framework. These include payment delays, lookbacks, and lockouts. The April 2019 User’s Guide to SOFR, (available here), also discusses conventions for in advance payment structures and hybrid models that can reduce the basis relative to in arrears.
It’s worth noting that while these term rates can be a useful tool for some and an integral part of the new financial ecosystem, hedging these rates will also tend to entail more costs than using SOFR directly and their use must be consistent with the functioning of the overall financial system. For this reason, the ARRC (Alternative Reference Rates Committee) sees some specific productive uses for a forward-looking SOFR term rate, in particular as a fallback for legacy cash products that reference LIBOR and also in loans where the borrowers otherwise have difficulties adapting to the new environment.
The conversion from LIBOR to SOFR requires users to have an understanding of how to enter the market rate, enter rate reset codes info, define instruments under deal management, enter deals info, and enter settlement manager info related to deals entered.
Navigating this change can be tricky, and Elire’s team of PeopleSoft experts are here to help. Reach out to [email protected] to connect with a member of our team and gain access to guides and materials to help with this transition. In the meantime, take a look at our Treasury consulting services here.