Part one of a series of articles on LIBOR’s phase out and the industry's transition to a new reference interest rate
November 2018 - The London Interbank Offered Rate (LIBOR) is the most widely used interest rate benchmark in the world, estimated to be referenced in $200 trillion worth of financial contracts. LIBOR is based on daily submissions of estimated borrowing rates by a panel of banks. Due to changes in the financial markets, the regulator of LIBOR will no longer compel these banks to continue submissions beyond 2021, resulting in the phase out of LIBOR as a benchmark interest rate.
In the United States, the Federal Reserve formed the Alternative Reference Rate Committee (ARRC) in 2014 to determine the implications of a LIBOR phase out and identify an alternative reference interest rate. The committee was also charged with creating a transition plan that would facilitate the transition from LIBOR to the identified alternative rate. This transition is now underway.
What is LIBOR?
LIBOR is published daily by the ICE Benchmark Administration for seven maturities and five currencies, including U.S. dollar LIBOR. LIBOR is meant to represent the cost at which large, globally active banks can borrow on an unsecured basis in wholesale markets, which include borrowing from other banks and issuing commercial paper.
Today, financial contracts valued at $200 trillion dollars – 10 times the size of the U.S. gross domestic product – reference LIBOR. Ninety-five percent of these contracts are for derivatives. However, USD LIBOR is also referenced in “cash products,” including business loans, floating-rate debt, securities, retail mortgages, and other consumer loans valued at more than $8 trillion. Simply stated, U.S. financial institutions use LIBOR to set the borrowing rate for everything from student loans, to car loans, to adjustable-rate mortgages.
Reasons for Phase Out
The volume of interbank lending based on LIBOR declined dramatically after the financial crisis because of changes in bank regulations and money market funds. As a result, the underlying market that LIBOR seeks to measure is no longer sufficiently active. LIBOR is increasingly based on the expert judgment of the panel of banks, rather than on actual transactions, making it a less meaningful rate. Some banks are growing uncomfortable providing submissions based on judgment instead of actual borrowings and may eventually choose to stop submitting.
In a speech in 2017, Andrew Bailey, the chief executive of the United Kingdom’s Financial Conduct Authority (FCA), the regulator of LIBOR, said that the FCA would not persuade or compel LIBOR panel banks to make submissions beyond the end of 2021. This date will likely represent the discontinuation of widespread use of LIBOR; market participants should treat the discontinuation as something that will happen and as something that they must prepare for.
In June 2017, the ARRC identified the Secured Overnight Financing Rate (SOFR) as its recommended alternative to U.S. dollar LIBOR. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. It is published by the Federal Reserve Bank of New York each morning and is determined based on transaction data comprising tri-party repurchase agreements, General Collateral Finance repos, and bilateral Treasury repo transactions cleared through Fixed Income Clearing Corporation. The New York Fed first published SOFR in April 2018.
Differences between LIBOR and SOFR
LIBOR is a forward-looking rate that is published for multiple terms, the most common being one, three, and six months, and includes a bank credit risk element for the term concerned. LIBOR rates are fixed at the start of the interest period.
SOFR is an overnight, risk-free reference rate that correlates closely with other money market rates and is based on actual transactions in a robust market. Volumes in the underlying repo market are reliability between $700 billion and $800 billion daily. SOFR is a backward-looking overnight rate based on transactions in the Treasury repurchase market and, therefore, does not have a term credit element, or spread, embedded into it. Unlike LIBOR, SOFR is a secured rate, collateralized using U.S. Treasuries. It is based on known interest payments at the next interest payment date.
The ARRC developed a Paced Transition Plan to help facilitate a smooth transition from LIBOR to SOFR and identify milestones until the end of 2021. Currently, the industry is ahead of the planned schedule – SOFR debt issuances have already occurred and the futures market is growing. Consumer products are on a slower track than others; however, the ARRC intends to provide recommendations on voluntary contract language for LIBOR loans by the end of 2018.
FHLBank Atlanta is committed to working with its shareholders and communicating regularly regarding potential implications of the LIBOR phase out and industry developments. The next article in this series will explore the key elements of a transition plan that financial institutions will need to develop to prepare for the LIBOR phase out.
Read part two of our series on the phase out of LIBOR to learn more about preparing for a transition to a new reference interest rate.