SOFR So Good? Why the LIBOR replacement could cause settlement issues, and how they could be avoided
In our view, the lookback features of the Secured Overnight Financing Rate (SOFR) rates, contrary to the forward-looking nature of LIBOR rates, presents potential issues and concerns around the calculation and settlement of SOFR-linked securities. We propose a solution that may improve market efficiency, reduce counterparty risk and more accurately calculate reserves.
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.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.