By David Blitzer
LIBOR - the London Interbank Offered Rate - is the benchmark for over $300 trillion of loans, derivatives and other financial instruments. LIBOR started in the syndicated loan market of the 1960s; today it is quoted in different currencies and maturities. Following scandals in 2012-2013, LIBOR is being replaced and will disappear in 2021.
For US dollar-denominated loans and derivatives, the replacement for overnight LIBOR will be SOFR (Secured Overnight Financing Rate). It is based on overnight REPOs used by the Fed as part of its interest rate management. The New York Federal Reserve bank began publishing SOFR this time last year. Other overnight rates are being established covering the UK, Europe, Switzerland and Japan. (See the table.) Initially, these will be quoted as overnight rates only; regulators and industry groups are beginning to discuss term rates for maturities longer than overnight.
Originally, London-based banks set LIBOR by sharing estimates of what each bank could expect to pay for to borrow overnight money without collateral. Today's process is more formal, however, LIBOR continues to be partially based on estimates of what overnight funding would cost a recognized bank. SOFR has two key differences: it is calculated from actual trades, not estimates. It is a secured rate based on REPOs of US treasury securities. Over time, SOFR may drop below LIBOR, since it is a secured rate. Further, in a crisis, a secured rate like SOFR rate could fall, while an uncollateralized rate like LIBOR rises.
In 1986, when LIBOR was well-established and widely used, the British Bankers Association, with the support of the Bank of England, formalized the LIBOR rate setting and changed the process to exclude the highest and lowest quotes in each setting. Beginning in 2007, there were rumors and articles in the press raising questions about the LIBOR process and suggestions that a bank might quote low rates to enhance its credit quality. In 2012, several banks were found to be manipulating the rate to their own advantage. A year later, in 2013, the European Union levied financial penalties totaling over $2 billion against a group of eight major banks. SOFR and other LIBOR replacements use actual trades from liquid markets to prevent a repeat of the scandals that plagued, and then, brought down LIBOR.
"Beyond LIBOR: A Primer on the New Reference Rates" BIS Quarterly Review, March 2019
The chart shows the Fed Funds rate, US dollar overnight LIBOR and SOFR over the last year. SOFR tends to move sharply at quarter-ends, when banks look to the repo market for window dressing. As more funds focus on SOFR, it may become less volatile.
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