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 also issued a set of 2019 Incremental Objectives, which complement the Paced Transition Plan by outlining key priorities and milestones in 2019 to support and prepare market participants for the transition.
In addition to the Paced Transition Plan and the Incremental Objectives, 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 syndicated loans, bilateral loans, floating rate notes and securitizations. These provisions are for market participants’ voluntary use in new contracts that reference LIBOR and were developed with the goal of reducing the risk of serious market disruption in the event that LIBOR is no longer usable. 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 transactions underlying SOFR regularly exceed $800 billion 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.
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. This note provides a high-level summary of the approach used to derive their estimated forward-looking term rates while a working paper provides a more in-depth discussion of the methodology. 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, adopted in October 2017, is shown below. As noted above, the ARRC also issued a set of 2019 Incremental Objectives, which complement the Paced Transition Plan.
- Anticipated completion: 2018 H2
2. Trading begins in futures and/or bilateral, uncleared, OIS that reference SOFR.
- Anticipated completion: by end 2018
3. Trading begins in cleared OIS that reference SOFR in the current (EFFR) PAI and discounting environment.
- Anticipated completion: 2019 Q1
- Anticipated completion: 2020 Q1
- Anticipated completion: 2021 Q2
- Anticipated completion: by end of 2021
October 25, 2018
- Financial Accounting Standards Board approved SOFR OIS as a benchmark interest rate for hedge accounting purposes
October 9, 2018
- CME Group cleared its first interest rate swap referencing SOFR (with PAI and discounting linked to SOFR)
October 1, 2018
- Intercontinental Exchange launched 1- and 3-month SOFR futures contracts
July 26, 2018
- First issuance of SOFR-linked securities
July 18, 2018
- LCH cleared its first interest rate swap referencing SOFR (with PAI and discounting linked to EFFR)
May 16, 2018
- International Swaps and Derivatives Association included a definition of SOFR for use in contracts governed by ISDA Master Agreements
May 7, 2018
- CME Group launched 1-month and 3-month SOFR futures contracts
April 3, 2018
- The New York Fed, in cooperation with the Office of Financial Research, began publishing SOFR