Transition from LIBOR
This transition is essential to a more sound and resilient financial system and requires a significant, coordinated effort.
The UK’s Financial Conduct Authority (FCA) is responsible for regulating LIBOR. FCA Chief Executive Andrew Bailey has made clear that the publication of LIBOR is not guaranteed beyond 2021, so time is of the essence to prepare for the possibility that the production and availability of LIBOR might cease permanently. The transition from LIBOR is important because the potential disruption or cessation of LIBOR poses a financial stability risk as well as a risk to the individual firms with LIBOR exposures.
While the precise volume of transactions in markets underlying LIBOR is unknown, estimates show that, on a typical day, the volume of three-month wholesale funding transactions by major global banks was about $500 million. This is a very low number compared to the $200 trillion of financial contracts referencing USD LIBOR.
The ARRC has identified the Secured Overnight Financing Rate (SOFR) as the rate that represents best practice for use in certain new USD derivatives and other financial contracts. To support the transition to SOFR, the ARRC developed the Paced Transition Plan, with specific steps and timelines designed to encourage adoption of SOFR. In order to develop sufficient liquidity, the ARRC is focused on supporting the launch and usage of SOFR-based financial products in the market and creating a forward-looking term rate based on SOFR.
The ARRC published recommended best practices that outline key transition milestones that market participants should aim to meet across floating rate notes, business loans, consumer loans, securitizations, and derivatives. The best practices outline recommended timelines for when robust fallback language should be incorporated, and dates after which no new USD LIBOR-based activity should be conducted. These best practices build on the ARRC’s 2020 Objectives, which aim to advance the ARRC’s work and mission.
In addition to the Paced Transition Plan and the recommended transition milestones, the ARRC is also working to address the fact that many contracts for products referencing USD LIBOR do not adequately account for the possibility that LIBOR may no longer be usable. To protect against this risk, the ARRC has released final recommended language on USD LIBOR fallback contract language for cash products. To learn more about fallback contract language, visit here.
In 2017, the ARRC selected SOFR as the rate that represents best practice for use in certain new USD derivatives and other financial contracts, representing the ARRC's preferred alternative to USD LIBOR. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities in the repurchase agreement (repo) market. This rate is robust, is not at risk of cessation, and it meets international standards. It is produced by the New York Fed in cooperation with the Office of Financial Research. The New York Fed publishes SOFR each business day at approximately 8:00 a.m Eastern Time.
SOFR is a much more resilient rate than LIBOR because of how it is produced and the depth and liquidity of the markets that underlie it. As an overnight secured rate, SOFR better reflects the way financial institutions fund themselves today. The transaction volumes underlying SOFR regularly are around $1 trillion in daily volumes. The volumes underlying SOFR are far larger than the transactions in any other U.S. money market. This makes it a transparent rate that is representative of the market across a broad range of market participants and protects it from attempts at manipulation. Also, the fact that it’s derived from the U.S. Treasury repo market means that, unlike LIBOR, it’s not at risk of disappearing.
In order to help explain how market participants can use SOFR in cash products, the ARRC released A User’s Guide to SOFR. This paper builds on the ARRC’s work developing the Paced Transition Plan and addresses a range of topics, including differences between using simple or compound averages of SOFR and differences between calculating payments using in arrears or in advance conventions. Also, in cooperation with the Treasury Department's Office of Financial Research, the New York Fed is publishing three daily compounded averages of SOFR: "30-day Average SOFR," "90-day Average SOFR," and "180-day Average SOFR," in addition to a daily index that allows for the calculation of compounded average rates over custom time periods: the "SOFR Index". By providing calculated term rates that can be easily cited in contracts, these average are facilitating the adoption of SOFR.
In addition, Federal Reserve Board staff members have published a FEDS note that includes data on indicative compound averages of SOFR and, based on a methodology they have proposed, estimated forward-looking term rates, that will be updated periodically. The data are for informational purposes only and are intended to help market participants better understand how forward-looking term and compounded SOFR may behave over time. The ARRC has set a goal of seeing a robust, IOSCO-compliant forward-looking term rate produced by a private administrator that could be used in commercial contracts once the SOFR derivatives markets that the term rate would be based on have grown to sufficient depth.
The Paced Transition Plan below includes specific steps and timelines designed to encourage adoption of SOFR. The timeline for the Paced Transition Plan, is shown below.1
- Anticipated completion: 2018 H2
- Completed 2018 H1
2. Trading begins in futures and/or bilateral, uncleared, OIS that reference SOFR.
- Anticipated completion: by end 2018
- Completed May 2018 (CME Group launched 1-month and 3-month SOFR futures contracts on May 7, 2018)
3. Trading begins in cleared OIS that reference SOFR in the current (EFFR) PAI and discounting environment.
- Anticipated completion: 2019 Q1
- Completed July 2018 (LCH cleared its first interest rate swap referencing SOFR on July 18, 2018)
- Anticipated completion: 2021 Q2
- Completed as of close of business on October 16, 2020
- Formally recommended the CME SOFR Term Rates on July 29, 2021
1 In the original formulation of the ARRC’s Paced Transition Plan set out in the ARRC’s 2017 Second Report, there had been six steps, with a Step 4 that involved CCPs providing a choice between SOFR and EFFR PAI and discounting environments for new trades (by 2020 Q1), and a Step 5 in which the CCPs would move to only offer a SOFR PAI and discounting environment for new trades (by 2021 Q2). In consultation with stakeholders, both CME and LCH subsequently determined that it was appropriate to move to the model outlined in the current Step 4, involving an immediate switchover from EFFR to SOFR PAI and discounting in a single step for both cleared new trades and legacy instruments in October 2020.
The original formulation of the Paced Transition Plan also had stated that the goal for the creation of a term reference rate was anticipated by the end of 2021. In line with the ARRC’s 2020 Objectives, this was since adjusted to note that the goal for completion is in the first half of 2021. The ARRC announced its formal recommendation of the CME SOFR Term Rates in July 2021.