“The LIBOR system is structurally flawed. It is a major problem for our financial system and for the confidence in the financial system. We need to address it..” - Ben Bernanke
The Alternative Reference Rates Committee (the “ARRC”), representing a group of private-market participants convened by the Federal Reserve Board and Federal Reserve Bank of New York, has announced on 29 July 2021 that it would be formally recommending CME Group’s forward-looking Secured Overnight Financing Rate (SOFR) term rates. That signifies the heyday of USD LIBOR is going to end and here comes the era for the SOFR.
LIBOR and SOFR explained
LIBOR, an acronym for London Interbank Offered Rate, has been the worldwide accepted benchmark interest rate for measuring borrowing costs amongst the banks. It is basically the average interest rate that the major banks will charge when borrowing from one another. The daily LIBOR rates are published by the Intercontinental Exchange and it is based on the five major currencies, including the US dollar, the EURO, the British pound, the Swiss franc, and the Japanese yen with seven maturities, including overnight, one week, one month, two months, three months, six months and 12 months.
LIBOR is used in interbank products, financial products, like derivatives, mortgages and bonds and also in consumer loan-related products. On a macro-level, it is a market indicator of interest rates to be set by central banks and the general healthiness of the banking system.
Coexisting with USD LIBOR, the SOFR has been published by the Federal Reserve Bank of New York since 2018. SOFR is “a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities in the repurchase agreement market”, and is basically a benchmark interest rate for USD-denominated derivatives and loans.
It is determined by reference to transaction data from tri-party repurchase agreements, general collateral finance repurchase agreements, bilateral Treasury repurchase agreements transaction cleared through Fixed Income Clearing Corporation, making SOFR a rather comprehensive representation of the funding conditions of the market.
Why SOFR over USD LIBOR
“We urge the Department of Justice to carefully investigate and aggressively prosecute all senior bank officials who participated in manipulating the London interbank offered rate throughout the financial crisis.” - Peter Welch
The Federal Reserve Bank of New York has made an effort to phase out USD LIBOR by publishing the alternative reference SOFR, and everything goes back to the financial crisis in 2008 (in light of the role LIBOR played in worsening the 2008 financial crisis as well as scandals involving LIBOR manipulation within various rate-setting banks) when the world started to give another thought of the financial and banking system.
Diminishing underlying transactions
LIBOR essentially reflects the average cost of short-term, wholesale unsecured borrowing of major banks’ average, yet banks have changed the way in funding themselves and they seldom see themselves involving in unsecured wholesale term borrowing. The result is that there are little actual borrowing to support LIBOR and some banks have in fact ceased to submit their estimates which in turn leads to a less representative LIBOR.
LIBOR is all about the estimates from the major banks while SOFR is about the actual transactions, and that means by using LIBOR, banks can fudged the data to yield higher profits for the derivative products based on LIBOR.
Robust underlying transaction
SOFR is based on the data of the repurchase agreements (repo) market, and the trading volume in the repo marketing is way more extensive than the interbank borrowings, rendering SOFR more accurate as an indicator of borrowing costs. In fact, trading volume of the repo market is larger than other money market in the United States, and the repo market covers more market participants.
Actual transactions to support
Rather relying on the estimate borrowing rates supplied by the major banks, SOFR is underpinned by actual transactions in the repo market, rendering it more reliable.
“None of this represented the glorious next stage of human evolution, but I was learning things. I was moving up.” - Robin Sloan
Transitioning to a new benchmark rate is never easy, and we may have to be alert to several points when it comes to commercial agreements using benchmark references:
Watch out for the deadlines: The Federal Reserve has encouraged banks to cease entering into new contracts that use USD LIBOR as reference rate by 31 December 2021. The UK Financial Conduct Authority confirmed that the most of the LIBOR settings will cease on 31 December 2021 and the USD - 1 week and 2 months one will be ceased on 30 June 2023.
Incorporate fall triggers and the fallback rates: Triggers may be the official discontinuation of LIBOR or merely a declaration that LIBOR is not representative. Market players are seen to have included provisions providing for a fallback rate being the specific substitute rate or index announced by a specific organization, like the Federal Reserve or the ARRC, or the rates eventually adopted by the market.
Beware of the substitute reference rate adopted by different countries: In Hong Kong, there is a multi-rate approach. Whilst LIBOR is extensively used, the Hong Kong Interbank Offered Rate (HIBOR) has been widely adopted by market participants as a reliable benchmark reference, and the Hong Kong Dollar Overnight Index Average (HONIA) has been seen as an alternative.
With the deadlines approaching, financial institutions should have planned ahead and ARRC announcement recommending SOFR term rates just serves as a final reminder that we should revisit the matter and assess our exposure to LIBOR contracts.
Apart from making appropriate adjustments to the contracts, other housekeeping matters, like upgrading the IT systems and internal models, communicating with counterparties and customers, will also have to be taken care of. As one of the world’s leading financial centers, practitioners in Hong Kong must prepare.
This article was first published in the October 2021 issue of the Hong Kong Lawyer, the official journal of The Law Society of Hong Kong. Please check it here: http://www.hk-lawyer.org/content/important-banking-law-update-libor-sofr-basics-explained-and-tips-provided
This article is co-authored by Joshua Chu from ONC Lawyer.