Thought Leadership

SOFR So Good? Why the LIBOR replacement could cause settlement issues, and how they could be avoided

David Knutson

David Knutson

Head of Credit Research, Americas

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LIBOR – the London Interbank Offered Rate – is supposed to represent the interest rate that big, healthy bank pay to borrow from another big bank. As a (nearly) risk-free reference rate, designed to be based on interbank transactions, LIBOR has long been considered a measure of the health of the global financial system.

LIBOR reference rates are used all over the world, for different currencies and maturities, as a base rate to which a spread is added for riskier investments. Apart from the $350 trillion of derivative transactions that are priced off LIBOR, it is also the reference rate for a substantial portion of credit markets.

LIBOR out, SOFR in

Initially it was proposed that LIBOR would be reformed, rather than replaced, but concerns over its vulnerability in times of stress (or to manipulation) led many banks to call for its replacement. The UK’s Financial Conduct Authority (FCA), the regulatory agency responsible for overseeing LIBOR, has arranged to sustain the fading reference rate until the end of 2021.

Beginning in January of 2022, current panel banks quoting interbank offered rates are expected to cease quoting LIBOR. Over the last couple of years, regulators and industry leaders1 have been undertaking initiatives to replace LIBOR with a new reference rate. After considering various alternatives, the Fed sponsored Alternative Reference Rate Committee (ARRC) selected the SOFR rate as the successor to LIBOR.

It is expected that the market will utilize some form of average of SOFR, as opposed to a single day’s reading of the rate, to determine the floating-rate payments that are to be paid or received. This is intended to more accurately reflect interest rates over the contract period and to smooth out any idiosyncratic, day-to-day fluctuations.