Names can have negative or positive connotations. In the financial world, some infamous names come to mind, such as “Ponzi” and “Madoff” that evoke feelings of dishonesty and scandal, based on the enormity of their respective thefts. We have never met anyone with the last name of Ponzi, but we’re sure there are a few Ponzi’s amongst us. We didn’t spend too much time researching how many Ponzi’s or Madoff’s changed their names, however we could assume many did. Any financial institution reviewing resumes would have second thoughts about hiring someone with a name associated with a couple of the world’s most famous crooks.
The point is that if a name that has been sullied and vilified to such an extent, often-times it cannot be saved. The same logic can be applied to the names of financial indexes. LIBOR, once called the “world’s most important number,” is an index which has, for almost 50 years, represented the cost for financial institutions to borrow from each other. It’s now associated with manipulation, collusion, and corruption. As such, something had to be done to rid the world of LIBOR forever. Thus began the search for a new rate that would evoke trust, credibility, and freedom from manipulation. A committee was formed, ARRC, to come up with an alternative to replace and eliminate LIBOR by all means necessary. Great idea, because the world is waiting. Mervyn King, British economist and former governor to the Bank of England, eloquently referred to LIBOR during the 2008 financial crises as “the rate at which banks do not lend to each other.”
It was determined by the committee that LIBOR should be executed at the end of 2021 and replaced by the Secured Overnight Financing Rate, aka “SOFR”. The new index is not a measure of the borrowing rate between banks like LIBOR, rather it is a risk-free rate calculated from repurchase agreement (“repo”) transactions which are collateralized by US Treasuries. So far so good, essentially a risk-free index with no apparent ability to be manipulated, and the Federal Reserve is behind it. You can’t get any better than that. Problem solved, right? Wrong.
We agree LIBOR must go away, but what is this beloved new alternative rate and how is it going to make us sleep better at night now that the nefarious LIBOR has been banished to the underworld? Our team has been conducting LIBOR-SOFR transition seminars for the past year, and over time we began to question the viability of this alternative rate. Lawyers, bankers, accountants, and bloggers are now expressing doubts about SOFR and are beginning to raise concern over its implementation.
- The rate is transaction-based and not determined by banks, nor based upon an almost non-existent inter-bank borrowing rate.
- The overnight repo market – upon which SOFR is based – is very liquid, and transaction volume is high.
- SOFR is published by the Federal Reserve. That adds credibility and eliminates the possibility of manipulation.
- Revenue generator for software companies (loan processing), lawyers, accountants, derivative advisors, and financial consultants (we jest, but true nonetheless).
- The “O” in SOFR stands for Overnight unlike the “O” in LIBOR, which stands for “Offered”. Why is that a problem? What about 1M, 3M, or 6M term rates? There are no SOFR term rates yet – a critical feature of any viable LIBOR replacement – but the committee is working on it. The proposed structure for determining SOFR term rates is unappealing at best; the rate of interest would be calculated based upon an average compounded overnight rate calculated in arrears. In other words, as a user of SOFR on a floating rate, mortgage-style loan, you won’t know what your interest rate is until after the interest period ends. Messy right? The remedy is a robust futures market where the data points create a curve that can be used to determine the rate at the start of each SOFR term. Just like how LIBOR works today.
- There is a nascent SOFR futures market, but liquidity is very low, and contracts go out only two years. It’s a start and an important step to developing a term rate.
- Shouldn’t a risk-free rate be better than LIBOR, which is unsecured and has implied credit risk? The answer is a strong no because financial institutions cannot borrow at the risk-free rate. This means there needs to be a broadly accepted method to adjust for credit risk. In our opinion this is a monumental task, because simply using a static spread to adjust the basis difference between risk-free and unsecured is not a constant. Spreads contract and widen based on perceived risk. A case in point: the Prime rate moves in tandem with the Federal funds rate. During the credit crises of 2008 however, the Prime rate remained static and LIBOR traded above Prime. An unusual occurrence given that the basis differential between 1M LIBOR and Prime is approximately 300 basis points most of the time.
- SOFR, which is essentially a repo rate, has been more volatile than overnight LIBOR since being published by the Fed and has become even more volatile due to Fed policy and Treasury issuance. The Fed has staged several bouts of intervention recently to maintain adequate liquidity for the market to function properly. Intervention could also be called…manipulation, no?
What if we just stick with LIBOR and call it something different and add more inputs to the calculation?
The Intercontinental Exchange (“ICE”), the current administrator for LIBOR, has a plan to do just that. It’s called the “Waterfall Methodology”.
- Track how banks borrow money in the commercial paper market, certificates of deposit, and money market accounts. This allows for a look at overnight and term rates.
- What if a bank wasn’t able to provide enough transactions for various terms? They should have the ability to come up with points on a curve based upon actual transactions.
- If a bank doesn’t have sufficient transactions to provide, then they would provide a rate based upon where they would fund themselves in the unsecured wholesale market place.
- A seemingly viable alternative to SOFR, but will it see the light of day? Who knows.
Take-Away: The LIBOR name needs to be banished from finance, no doubt, but does that mean that its replacement has to function so differently? Consider all of the ramifications to existing loan agreements, derivative contracts, interest rate calculations, alternative rate language, industry-wide support and let’s not forget back-office loan processing systems. It’s like Y2K for the financial markets and is mindboggling just to think about all the details. SOFR is a reality, but we are going to be an outlier and suggest that SOFR will not be the only alternative rate that’s used at the end of the day. If we are correct in our assumptions, we should start receiving calls from CNBC and all the business news channels for interviews on how we came up with such a bold forecast. It will be several years before we find out.
Not sure how LIBOR’s transition to SOFR will impact you? Want to know more about the mechanics of the change and how your business could be exposed? Contact us for a free, no obligation deep dive into how best to prepare.
LIBOR vs SOFR
Clearly there is a relationship between the indices, but SOFR as an overnight rate is more volatile
Source: Bloomberg Professional
REPO Rates versus SOFR
SOFR is highly correlated to Repo rates, as it should be, but the difference is SOFR is calculated as a volume-weighted median of Repo transactions
Source: Bloomberg Professional
SOFR versus Other Overnight Rates
Overnight rates move in tandem, however when there is credit stress or supply/demand issues, dislocations become apparent
Source: Bloomberg Professional