The fall of LIBOR and the rise of SOFR

Authored by Johanna Arasin

The London Interbank Offered Rate (LIBOR) and other interbank offered rates are some of the most widely used benchmarks around the world. Today, USD LIBOR is referenced in approximately $200 trillion worth of financial contracts, which will not be the case for long. It was first announced in 2017 that LIBOR is set to be phased out after 2021. The pressure now is to successfully transition to an alternative reference rate.

LIBOR is inherently subjective, as it is an estimate of what a select group of banks charge each other for short-term loans. During the financial crisis of 2008, LIBOR displayed volatility and was not behaving in line with other short-term interest rates, which sparked the LIBOR reform discussion.

The need for change became particularly prevalent in the 2012 LIBOR scandal when the U.S. Department of Justice opened a criminal investigation into LIBOR abuse. It was discovered that multiple banks colluded to manipulate LIBOR rates for their benefit, which had global implications. Major financial institutions such as Barclays, Deutsche Bank, Citigroup, JPMorgan Chase and the Royal Bank of Scotland were all implicated in the scandal and faced hefty fines. This only further encouraged policymakers and regulators to cease the use of LIBOR.  

The Federal Reserve, along with the Federal Reserve Bank of New York, assembled the Alternative Reference Rate Committee (ARRC), which will help to implement the transition from LIBOR to an alternative reference rate. The ARRC is comprised of private market participants including major banks, asset managers, insurers and industry trade organizers and regulators. Chaired by Tom Wipf, a vice chairman at Morgan Stanley, the ARRC was tasked with three main objectives:

1. Finding a robust reference rate that is transaction based as opposed to the subjective LIBOR. For the U.S., they identified the Secured Overnight Financing Rate (SOFR) as the preferred alternative rate. Whereas LIBOR terms could range from overnight to one year, SOFR is only an overnight rate. Produced by the New York Fed and published each morning at 8 a.m. EST, it is based on actual transactions, and is therefore less subjective.
2. Facilitate a smooth transition to SOFR.
3. Establish best practices for fallback language and contract design. The AARC established the Paced Transition Plan as a guide that includes target timelines. The plan sets early 2021 as the goal for creating a term reference rate based on SOFR derivatives markets. The Financial Accounting Standards Board (FASB) also issued ASU No. 2020-04, Facilitation of the Effects of Reference Rate Reform on Financial Reporting, as guidance to assist with this transition, which created the new Topic ASC 848, Reference Rate Reform. The amendments included within this ASU provide optional expedients and exceptions for applying generally accepted accounting principles to contract modifications and hedging relationships that are made up to Dec. 31, 2022, subject to certain criteria. 

The bottom line: LIBOR is on its way out, and SOFR is on its way in.

For more information on this topic, or to learn how Baker Tilly’s Value Architects™ can help, contact our team.