LIBOR vs SOFR: Why the Replacement?

Introduction

There was a time when LIBOR was the rate used in global markets. Internationally it was the standard and basis for the terms of securities. In the last decade this all began to change after allegations and investigations led to a regulatory crack down and legislation.

What is Wrong with LIBOR

What is LIBOR?

The London Interbank Offered Rate, or LIBOR, is a daily published benchmark interest rate used by banks to price short-term loans to other banks. It also has uses by everyday investors to price some financial instruments, making it also a reference rate. These other instruments affected include include variable rate loans, adjustable rate mortgages (ARMs), and private student loans. LIBOR, as a benchmark, is also used as a barometer to tell the finacial health of the market. As the indicator tracks the relative cost terms, and therefore risk, of a bank to loan to the world's largest and most financially stable institutions on a short term basis. To say the least this rate indicated the rate charged of some of the lowest risk institutions in the world.

Origins

The origins of LIBOR date back to 1969 when a banker by the name of Minos Zombanakis arranged for an $80 million loan from Manufacturer's Hanover to the Shah of Iran. This loan was unique at the time in that the rate on the loan was set by the reported funding costs of a panel of banks. Meaning this rate was seen as fair reading of what the terms of the loan would be to any number of other institutions at the time. This perceived fairness and the built in average of the best rates given to the largest institutions were seen as a useful indicator and starting point. This led to an adoption in the banking industry. By the mid 1980's the British Bankers' Association (BBA) formalized the process of collecting the rate tallies and governance of the rate going forward.

Use in Financial Markets

1986 had LIBOR fixings calculated for the British Pound, United States Dollar, and the Japanese Yen. By 2012 there were over ten currencies with tied fixing rates. Used as a reference, rates for consumer based financial products grew to rely upon its daily publication. The rate began being used to price mortgages, credit cards, and even student loans. Its wide usage can be drawn from its originating purpose. As this rate represented the terms the world's largest and most financially stable institutions were able to obtain funding. Then as a starting point it could offer a general lower bound for the cost of raising capital for other less stable financial institutions and eventually individuals.

LIBOR manipulation scandal

Although seemingly fair, LIBOR has a major flaw that lead to its downfall, incentive. The same banks that input their rate into the score, were also the same that borrowed and issued paper at the rate. By manipulating the value a panel bank provides, they can in tandem with other banks artificially depress or increase the rate. When debts owed to the bank were high, then there might be a strong incentive to lower the cost of that debt. In 2007 and 2008 the global financial markets were in the midst of the Great Recession. Lending money became much more risky, and as such the rate for borrowing began to jump. Banks clamored to shore up liquidity by borrowing more capital while at the same time issuing less capital to be loaned to other banks due the uncertainty of whether some of those institutions would weather the financial storm. There were indications that LIBOR was doing something interesting during this period. Unlike other rates LIBOR was not at times rising as high as other comparable rates. As the dust settled after the Great Recession regulators began investigations and queries into some of the largest banks. In 2012 individual panel bank submissions came under investigation by regulators. The accusation, the banks were underreporting the borrowing costs by significant amounts in order to project market strength during the crisis and to increase profits on deals. The largest offenders during this time were Barclays, UBS, RBS, and Rabobank. Charges were filed for false reporting penalized under of the Commodity Exchange Act. This became a large shock to a global system that had by this time come to heaily rely upon the rate. A search for a replacement was necessary.

So SOFR

In comes the Secured Overnight Financing Rate

The US Federal Reserve's Alternative Reference Rates Committee (ARRC) on June 2017 selected SOFR as the preferred alternative to LIBOR. With December 31st, 2021 being the deadline to transition fully any new contract away from LIBOR. August of 2018 had Barclays, one of the fined conspirator banks in the LIBOR scandal, borrowing using the new rate.

Why it was chosen

SOFR differs notably from LIBOR in that the rate is tied to actual transactions instead of rates submitted by a panel of banks for a hypothetical loan. Because these are actual transactions in the previous trading session, then there can be some assurance that the rate is a more fair representation of the going market rate. SOFR itself is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. It is calculated as a weighted average of the interest rates on overnight Treasury repurchase agreements (repos).