The London Interbank Offered Rate (LIBOR) is currently the world’s most widely used benchmark for short-term interest rates. Plans are underway to phase out LIBOR as a benchmark interest rate as soon as the end of 2021.

In the United States, the Alternative Reference Rates Committee (a committee of market participants convened by the Federal Reserve Board and the New York Fed) identified the Secured Overnight Financing Rate (SOFR) as its recommended alternative to U.S. dollar LIBOR.

FHLBank San Francisco issues SOFR floating rate notes, uses SOFR derivatives to hedge interest rate risk, and offers SOFR-linked advances to our members.

Why is LIBOR being phased out?

LIBOR is based on the rate submissions by panel banks as to the rate at which they could borrow funds on the wholesale unsecured term bank funding markets.

LIBOR panel banks are hesitant to provide these rates today because the volume of actual transactions in the wholesale unsecured term bank funding markets has dwindled since the financial crisis for various reasons.

The chief executive of the UK Financial Conduct Authority (FCA), the regulatory entity that has overseen LIBOR since 2014, announced that after 2021 the FCA would no longer persuade or compel LIBOR panel banks to submit the interbank borrowing rates required to calculate LIBOR.

After that date, it is uncertain whether panel banks will continue to submit rates of their own accord.

What is replacing LIBOR?

The Federal Reserve and the New York Fed convened the Alternative Reference Rates Committee (ARRC) in 2014 to determine the implications of a LIBOR phase out and identify an alternative reference interest rate. In June 2017, the ARRC identified the Secured Overnight Financing Rate (SOFR) as its recommended alternative to U.S. dollar LIBOR.

SOFR is a broad measure of the cost of borrowing and lending cash overnight collateralized by U.S. Treasury securities.

How is SOFR different from LIBOR?

LIBOR is a forward-looking rate that is published for multiple terms (typically one, three, or six months) and includes a bank credit risk element for the term concerned.

SOFR is an overnight, risk-free reference rate and does not include a term credit element. Unlike LIBOR, SOFR is based on actual transactions in a robust market. SOFR volumes reliably remain close to $1 trillion, on a daily basis, whereas volume in the markets on which LIBOR is based is often less than $1 billion.

Why did the ARRC choose SOFR as an alternative to LIBOR?

In choosing SOFR as its preferred alternative to LIBOR, the ARRC cited the depth and robustness of the Treasury repo market, where around $1 trillion is traded daily, and also noted that SOFR’s market is resilient, having operated smoothly during the financial crisis.

Is SOFR active now?

Yes. On April 3, 2018, the Federal Reserve Bank of New York began publishing SOFR.

What is FHLBank San Francisco doing to prepare for the LIBOR-to-SOFR transition?

FHLBank San Francisco is implementing its LIBOR transition plan in anticipation of LIBOR being phased out as soon as the end of 2021. Our plan will be updated often as we follow developments in LIBOR and SOFR. We will announce changes that affect members with various forms of communication up to and beyond 2021.

Are SOFR swaps eligible for clearing?

Yes, they clear at both the Chicago Mercantile Exchange (CME) and the London Clearing House (LCH). To see the volume of SOFR swaps on a Bloomberg terminal, type SDR [go], choose “rates,” and choose “SOFR.”  (You can see the Overnight Index Swaps (OIS) in the same way on the same screen).

What issues do lenders need to pay attention to when reviewing the documentation of contracts with a LIBOR component to ensure a smooth transition when LIBOR ceases to exist?

The language in your loan contracts may be ambiguous and open to interpretation based on how LIBOR ceases to exist. Some of the alternatives are:

  1. The Financial Conduct Authority of the UK may deem that LIBOR is not representative of the market and LIBOR is no longer published.
  2. The Financial Conduct Authority of the UK may deem that LIBOR is not representative of the market with a future date for cessation of LIBOR.
  3. The Financial Conduct Authority of the UK may deem that LIBOR is not representative of the market but ICE (the LIBOR Administrator) may continue to publish LIBOR because dealers continue to contribute their estimates of LIBOR and LIBOR continues to be published.
  4. ICE may stop publishing LIBOR without a statement from the Financial Conduct Authority.
  5. ICE may come up with an alternative estimation model/framework and continue to publish an index, calling it LIBOR.
  6. LIBOR ceases to be updated and the LIBOR rate remains at the same level and is published daily – essentially a fixed rate.

In addition, it is not just the index that needs to be changed, but the spread to the index, also known as the margin. Unlike LIBOR, SOFR does not currently have a term component (there is no term SOFR at this time, although it is envisioned). There is also no credit component because SOFR is based on Secured Treasury Repurchase transactions. LIBOR includes both of these components. ISDA has announced that they have selected Bloomberg to provide data on the spread adjustment when moving from LIBOR to SOFR. This process is still evolving, and the exact methodology for this calculation has not been announced by ISDA or Bloomberg. Lenders should monitor developments in this area at ISDA to determine the adjustment needed when moving from LIBOR to SOFR. Other helpful resources include the ISDA announcement regarding the fallback adjustment vendor and the ARRC’s recommendations for fallback language.