SOFR Cheat Sheet:
LIBOR’s End Has Arrived
Have you put off learning about SOFR? As of January 2022 you may find your bank unwilling to offer LIBOR based contracts. As we’ll see below, you are now forced to deal with SOFR, the new floating rate index. This SOFR cheat sheet will help you get started.
We’re asked every day about the ongoing LIBOR transition to SOFR. Here’s an overview of what’s happening, what it means for borrowers, lenders and legal counselors, and an outline of what each should begin doing now.
What’s wrong with LIBOR? Why is it being replaced?
Since the mid-1980’s, the London Interbank Offered Rate, better known as LIBOR, has been used to price trillions of dollars’ worth of financial products: everything from securities, student loans, interest rate hedges, credit cards, and mortgages. For commercial real estate, LIBOR has been the dominate index used to calculate interest due on floating rate loans as well as fixed-rate loans locked via a swap rate (e.g. CMBS).
Unfortunately in the past LIBOR was manipulated and regulators determined the index no longer reflected true market conditions.
In the aftermath of the 2008 financial crises a world-wide LIBOR manipulation scheme by large banks was uncovered, and a litany of scandals and billion-dollar fines ensued, prompting regulators to ask: Is LIBOR serving the purpose for which it was intended? Is it the best we can do? In short, their answer was an unequivocal “NO”. Ever since regulatory officials have been slowly but surely planning for LIBOR being phased out and steadily implemented the plan for a transition to “alternative benchmarks”, beginning now and to be complete by July, 2023.
Who’s running the LIBOR transition to SOFR show?
The Alternative Reference Rates Committee, (“ARRC”). It’s a group of bankers, attorneys, and regulators, organized by the Federal Reserve Board and the New York Fed, to help ensure a successful transition from LIBOR to a more robust reference rate. The ARRC recommended the Secured Overnight Financing Rate (“SOFR”) replace LIBOR, but hasn’t yet mandated anyone use SOFR. Using SOFR in place of LIBOR is strictly voluntary, but the SEC has put pressure on banks to adopt SOFR rather than credit sensitive indices. This may change once SOFR is firmly in place. You can learn more about ARRC on their website .
What is SOFR? Why is it the preferred replacement for LIBOR?
In short, SOFR is tough to manipulate and represents the cost of money better than LIBOR.
Unlike LIBOR, SOFR is a broad measure of the cost of borrowing cash overnight, collateralized by U.S. Treasury securities. It’s based on actual overnight loans between parties, which take place in the repurchase agreement (“repo”) market. It’s published by the New York Fed each business day at approximately 8:00 a.m. Eastern Time. However, some market participants claim the repo market isn’t as transparent as we are often led to believe.
In contrast, LIBOR was originally designed to employ the interest rate large banks charge each other for loans on an uncollateralized basis. LIBOR is an “estimated” rate in that it isn’t based on any actual loans between banks, but rather it is based on participating banks asking themselves, “If we, Bank X, were to loan money to Bank Y today for a given term, then this is the interest rate we would charge”. Notice, Bank X need not have actually loaned money to Bank Y and might never do so in the future, but if it did, the interest rate they report for the LIBOR calculation is the interest rate they say they will charge. In essence, LIBOR is a hypothetical offer, not a transaction. And since banks haven’t really lent to one another via LIBOR in years, LIBOR no longer represents what it was designed to be. Given the trillions of dollars of financial transactions based upon LIBOR, that’s a big problem.
Conversely, SOFR, because it’s calculated from actual transactions between parties, is deemed to be a better representation of the overnight cost of money, again, transactions that are collateralized by ultra low risk U.S. Treasury securities. SOFR is derived from overnight, collateralized loans, whereas LIBOR is based on unsecured, term loans, therefore SOFR should generally be a LOWER rate than LIBOR.
What are the underlying drivers that move SOFR?
As mentioned, SOFR is based upon actual overnight loans between parties, which take place in what is called the repo market. Repo markets are where banks, other large financial institutions, and corporations borrow or lend money backed by liquid securities, most commonly US Treasury bills, for short periods of time, usually overnight. The following are some of the factors that influence Treasury repo supply and demand, and therefore the SOFR rate:
• The Fed Funds Target Rate:
SOFR’s greatest influencer, this rate is set by the Federal Reserve during its monetary policy meetings. The Fed publishes it in the form of a “lower bound” and “upper bound” range. As the Fed moves the range around, SOFR moves in concert. The “lower bound” sets a floor below which SOFR is unlikely to fall.
• Financial market stress:
Any large sell-off in “risk assets,” such as stocks, corporate bonds, and real estate, increases demand for Treasury repo collateral, driving up repo rates and SOFR along with them.
• Reduced bank balance sheet availability:
At quarter and year-end, the balance sheets of large banks come under stress due to the financing and liquidity demands of their clients. These short-term demands on banks are frequently met through the repo markets, which raises repo rates. As a direct result, SOFR will typically surge at quarter and year-end due to this phenomenon.
• Money-market fund sensitivity to US issuance of Treasury bills:
Money market funds make up around half of the repo market activity used to compute SOFR. Repo, Treasury Bills, and discount notes are common investments for money-market funds. Increased Treasury Bill issuance by the US Treasury will raise yields, encouraging money-market funds to substitute Treasury bills for repo assets, causing repo rates and by extension SOFR, to rise.
But wait, if SOFR is a daily, market driven rate, won’t it be volatile?
Yes. The Treasury repo market’s mechanics make daily spot SOFR more volatile than LIBOR. The SOFR powers-that-be know this and have come up with a handful of suggestions – for example, to average daily SOFR over a defined period – to try and flatten out its peaks and valleys. Some of their suggestions to do this are as follows:
• Simple daily SOFR in arrears:
Simple average of daily SOFR during an interest period, say one-month, determined at the end of the period.
• SOFR compounded in arrears:
Compounded daily SOFR during an interest period, determined at the end of the period.
• SOFR compounded in advance:
Compounded rate based on daily SOFR during the previous 30, 60, or 90 days, determined at the beginning of an interest period.
If you’d like to learn more about how SOFR is inherently more volatile than LIBOR, and how that dynamic can impact your interest expense, check out our report: Repo Madness.
What is Term SOFR?
SOFR’s initial design lacked one major component that lenders and borrowers crave, a forward curve. In contrast to SOFR, LIBOR offers a full forward curve which gives participants the ability to borrow, lend, and hedge at “term” rates in various time increments – like 1,3 or 6 months – looking forward. SOFR is an overnight rate, offering no term structure of any kind. (If we were on the ARRC committee, we would have recommended SOFR, 1MSFR, 3MSFR).
Market players avoided adopting SOFR early on because of this and SOFR’s governing bodies responded with “Term SOFR”: A forward-looking version of SOFR determined by market expectations for where SOFR may be in the future. As a result, there are now 1-month, 3-month, 6-month and 12-month versions of SOFR, just like there is for LIBOR.
Is SOFR the only replacement for LIBOR?
No. While SOFR is currently the predominant replacement of LIBOR in loan agreements, bonds and interest rate swaps and caps, many players in financial markets are choosing instead to use other replacements for LIBOR.
As an example, some regional banks and specialty lenders (like in commercial real estate) have said they would prefer a LIBOR replacement rate that incorporates a credit risk element. Remember, SOFR is based on overnight loans collateralized by U.S. Treasury securities. Hence, it’s technically a risk-free rate. Whereas LIBOR is uncollateralized and inherently reflects the credit risk of large banks. SOFR by design doesn’t represent credit risk whatsoever, whereas LIBOR does.
Many lenders don’t favor SOFR, because a portion of their own cost of funds includes a dynamic credit component, which often widens during times of market stress. Repo rates, i.e. SOFR, on the other hand, typically narrow during times of market stress due to their risk-free nature. As a result, a bank’s cost of funds may rise while the floating rate at which it’s lending remains stable or falls. Additionally, because SOFR is a daily rate based on an active repo market, it tends to be volatile, as discussed above.
In this SOFR cheat sheet we can point to other replacements for LIBOR that are gaining traction include the following:
• The Bloomberg Short-Term Bank Yield Index (BSBY): A credit-sensitive reference rate that incorporates a basket of bank funding costs and includes a forward term structure, like LIBOR.
• The AMERIBOR unsecured overnight rate:
Based on unsecured loan markets (similar to LIBOR). AMERIBOR reflects the actual unsecured borrowing costs of more than one thousand US banks and other financial institutions, largely community and regional banks that lend to smaller institutions.
• The US Dollar ICE Bank Index:
Measures yields on one, three and six month terms. The index is forward looking and credit sensitive, and operates similar to LIBOR, but better.
• Commercial Paper Rates:
The interest rates charged to corporations for uncollateralized short-term loans. Published daily by the Fed’s Board of Governors, the rates are derived from data supplied by The Depository Trust & Clearing Corporation (DTCC), a national clearinghouse for the settlement of securities trades and a custodian for securities that taps nearly all aspects of the Commercial Paper markets.
While we can’t go into detail in this cheat sheet on whether these SOFR alternatives may be better for you, feel free to give us a call, (415) 510-2100, for a breakout of the pros and cons of each for your specific situation. In the meantime, just know that SOFR is not the end all, be all, of LIBOR replacements. We’ll likely end up with multiple replacements for LIBOR, with each designed to best serve different segments of the lending and hedging landscape.
And now, back to LIBOR for a moment: Will LIBOR suddenly become unavailable in 2022?
No. Since its standardization in 1984, LIBOR has been published daily by 18 large international banks. There are a total of 35 rates posted each day, collectively known as IBOR rates. Interest rates are compiled for seven different maturities for each of 5 major currencies: the Swiss franc, the Euro, the British pound, the Japanese yen, and the U.S. dollar.
After mid-2023, most of these 35 IBOR rates will still be published, including LIBOR. It’s just that the banks participating in publishing them won’t be legally required to do so. However, LIBOR will slowly but surely become unreliable as a representative benchmark. In addition, as assets become increasingly priced based on non-LIBOR indices, LIBOR trading markets will become much less liquid, driving up hedging costs of LIBOR. Hence, it’s best to begin establishing a game plan now for LIBOR to ultimately become unusable or unavailable.
Will LIBOR indexed loans, rate caps and swaps be available after 2021?
Yes, but with major limitations.
In late 2020, the Fed, the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation (FDIC) issued a joint statement that essentially discouraged banks from entering into any new LIBOR indexed financial contracts after December 31, 2021. The powers-that-be suggested institutions begin using a reference rate other than LIBOR (e.g, SOFR) beginning in 2022.
How Does the Discontinuation of LIBOR Impact my Swap or Rate Cap?
As a direct result, large banks, debt funds and bridge lenders slowly but surely began switching from LIBOR to SOFR in many of their new loans and derivatives used to hedge interest rate risk, like rate caps and swaps, in mid to late 2021, with the expectation that they’d make the switch on the vast majority of new loans and derivatives in early 2022. For rate caps specifically, most banks don’t plan on offering any new LIBOR-indexed rate caps to hedging customers in 2022, with certain exceptions. Okay, we’ve covered new loans and rate caps, but what about existing ones?
Imagine your bridge lender just informed you that your LIBOR-indexed, floating rate loan will switch from LIBOR to SOFR in early 2022. Will you have to change the reference rate in your swap or rate cap in concert with the loan change?
Probably. Given the potential numerical difference between LIBOR and its replacement, your interest rate swap or cap may become less effective when the LIBOR transition takes place, resulting in something markets call “basis risk” (the loan references one rate, SOFR, but your interest rate hedge references something different, like LIBOR). In such a case, you have a choice, leave the reference rate as is and suffer the consequences of the differences or change it so that it’s consistent with the index used in the loan:
1. If you elect to change it, your hedging bank will likely charge you a fee to do so. How much? It depends; the fee is determined on a case-by-case basis. Ask us for help, OR
2. Adhere to the IBOR Protocol.
What’s the IBOR Protocol?
As part of the process of lenders and financial markets transitioning away from LIBOR, the International Swaps and Derivatives Association (ISDA) published its 2020 IBOR Fallbacks Protocol (the Protocol) and related Amendments to the 2006 ISDA Definitions (the Amendments). These documents, together, represent a significant step toward the standardization of modifying interest rate swap and cap contracts to transition away from LIBOR.
What is the International Swaps and Derivatives Association (ISDA)?
The International Swaps and Derivatives Association (ISDA) is a trade collective made up of more than 800 market participants (bankers, lawyers, and large derivatives end-users, mostly) from almost 60 countries around the world. In 1992, the association developed a standardized contract called the ISDA Master Agreement, which is now used as the de-facto contract for interest rate swaps and rate caps. If you’ve ever bought an interest rate cap or interest rate swap, it’s highly likely the legal contract you signed to govern that transaction was an ISDA Master Agreement.
What’s the ISDA Master Agreement?
The ISDA Master Agreement is an umbrella agreement between two parties which defines the overarching legal terms of the derivative transactions into which they enter. Each swap or rate cap that is subsequently executed between the parties is memorialized in what’s called a “Confirmation” which defines the business details of the transaction and references the ISDA Master Agreement terms. The vast majority of the world’s swap and rate cap transactions are documented under the standardized ISDA Master Agreement, which, when originally drafted, didn’t anticipate a move away from the use of LIBOR.
As such, many borrowers who have a swap or own a rate cap are left to navigate a minefield of legal potholes – many of which can have a negative financial impacts – unless some change is made to the underlying ISDA Master Agreement to address the shortfall.
The ISDA IBOR Fallback Protocol serves to address this gap by providing a standardized mechanism for you and the bank that sold you the swap or rate cap to bilaterally amend the transaction to incorporate new ISDA terms, which provide for a clear transition from LIBOR to SOFR upon the occurrence of certain objective, easily observable events – like LIBOR simply disappearing – allowing you to avoid the uncertainties and clumsy mechanics that existed before the Protocol.
How Do You Sign Up to Use the Protocol?
Your or the swap bank’s decision to use the Protocol is referred to as “adherence.” The process of adherence can be done directly through ISDA’s website. Adherence costs $500 per legal entity, and may be completed at any time. After your adherence, the Protocol’s amendments to your swap or rate cap contract become effective immediately.
Many lenders are being proactive about notifying their swap and rate cap customers of the existence of the Protocol and are encouraging them to adhere. Haven’t heard from your lender yet regarding the Protocol? While adherence is certainly a consideration for many borrowers, there are risks in doing so.
What are the Risks in Adhering to the Protocol?
While it seems that your adherence is a slam dunk, it isn’t. There are risks. Specifically,
1. A mismatch between your loan and interest rate hedge:
The reason you have a swap or a rate cap in the first place is because you hedged the financial risk inherent in a floating rate loan. Further, it’s important to remember that your loan agreement and your swap or rate cap contract are separate, but related agreements. Just because you adhere to the Protocol, and thereby agree to amend your swap or rate cap to transition to SOFR in the future, it doesn’t mean that your loan agreement will also transition to SOFR nor do so at the same time as the rate cap or swap. Should your lender decide to transition from LIBOR to something other than SOFR, and you’ve adhered to the Protocol, you could be left in a situation where your floating rate loan is indexed to one benchmark, say BSBY, and your rate cap or swap is indexed to SOFR. Such an outcome would result in a mismatch in the floating rates in each contract and ultimately leave you with a less effective hedge.
2. A mismatch between SOFR and the LIBOR rate it replaces:
By adhering to the Protocol, you’re agreeing to transition your swap or rate cap from LIBOR to SOFR in the future. While the ARRC, referenced above, is certainly doing its best to get SOFR ready for prime time, one possible outcome of adherence is a material mismatch between the numerical value of SOFR and LIBOR (e.g., 0.05% versus 0.10% respectively), which could result in unwanted credit spread adjustments – against you – by your lender.
What should you do now?
After reading this SOFR cheat sheet you will realize that LIBOR’s sunset is here – it’s a fact. As such, existing LIBOR-based loans and interest rate swap and rate cap contracts will have to be modified, and far in advance of 1-month LIBOR’s official transition deadline in June, 2023. While the Protocol provides a uniform, efficient way to amend a swap or rate cap, such a method doesn’t exist for loans. Before adhering to the Protocol, we suggest you consider the following:
• Don’t take your lender’s word for it:
Get educated or seek sound advice from a professional, like us at Derivative Logic, to give you a full list of pros and cons of adherence for your specific case. After absorbing the information in this SOFR cheat sheet, please call us at (415) 510-2100.
• Talk to your lender:
Gain a sense of how and when your loan will transition from LIBOR, and to which new benchmark it will transition. Many lenders, especially large banks, plan to transition their loans to SOFR and do so at the time that the ISDA IBOR Protocol outlines. Have you borrowed from a regional or community bank or non-bank lender? It’s likely that their choice of LIBOR replacement and timing won’t line up with your swap or rate cap.
• Adhere to the ISDA Protocol:
If you’re feeling confident, head on over to ISDA’s Protocol Adherence website and start the process. You’ll find that it’s a bit clunky. And you can always reach out to us for help or allow us to do it for you.
Confused? Not sure where to start? Finding it confusing to understand the nuances of the LIBOR transition?
Reading our SOFR Cheat Sheet is a good start. However, we won’t stop there! We’ve got your back. Call (415) 510-2100 or email us today. We will help you explore your specific situation in detail and craft the Straight to Smart path for you and your company.