Understanding LIBOR

It was introduced in 1969 and has since been used in the calculation of interest and other payments due on trillions of dollars of loans, derivatives, bonds and other financial transactions. The calculations have been published daily across a range of currencies (GBP, USD, EUR, JPY and CHF) and maturities by the Intercontinental Exchange (ICE) Benchmark Administrator (BA) based on submissions from a panel of banks.

Moving towards more transparent trading

The underlying market that LIBOR is derived from is no longer used in any significant volume. Therefore, the submissions made by banks to sustain the LIBOR rate were often based (at least in part) on expert judgement, rather than actual transactions.

The UK’s Financial Conduct Authority (FCA) has concluded that the way in which LIBOR was calculated in practice means that it no longer complied with internationally accepted principles for robust interest rate determination.

In 2017, the UK's Financial Conduct Authority announced it would no longer compel panel banks to continue to provide LIBOR submissions beyond the end of 2021. Thereafter, discussions around the transition of LIBOR rapidly advanced and market participants prepared for the transition to alternative methods to support a sound and resilient financial market.

Alternative Reference Rates the new norm

Working groups from around the world proposed Alternative Reference Rates (ARRs) to replace LIBOR and have been working to substantially strengthen existing rates (US dollar, Euro, British pound, Japanese yen and Swiss franc).

Five ARRs emerged as alternatives to LIBOR. These ARRs differ by region, currency, tenor, and basis.

1. SOFR – overseen by the Federal Reserve Bank of New York (secured rates)
2. SARON – administered by Zurich-based SIX Exchange (secured rates)
3. SONIA – Bank of England (unsecured rates)
4. €STR – European Central Bank (unsecured rates)
5. TONA – Bank of Japan (unsecured rates)

Term SOFR

The Alternative Reference Rates Committee (ARRC) formally recommended the CME Group’s forward-looking Secured Overnight Financing Rate (SOFR) term rates (SOFR Term Rates) on 29 July 2021. Link

The ARRC announced that it:

• Supports the use of SOFR Term Rates for business loan activity, where adapting to an overnight rate could be more difficult.
• Does not support the use of SOFR Term Rates for derivatives markets, except for end users to hedge cash products using the SOFR Term Rates; and
• Continues to recommend using forms of overnight and averages of SOFR where possible.

Full details of the methodology used for SOFR Term rates: Link

A link to Frequently asked questions on the CME website regarding SOFR Term rates: Link

SOFR First

On July 13, 2021 the Commodity Futures Trading Commission’s (CFTC) Market Risk Advisory Committee (MRAC) adopted a market best practice known as SOFR First for consideration by the full Commission. SOFR First is a phased initiative for switching trading conventions from LIBOR to the Secured Overnight Financing Rate (SOFR) for U.S. Dollar (USD) linear interest rate swaps, cross currency swaps, non-linear derivatives and exchange traded derivatives.  View the CFTC press release

Differences between ARRs and LIBOR

ARRs are structured differently from LIBOR rates and as such have implications for how interest and other payments may be calculated. LIBOR is a forward-looking term rate, which means that the LIBOR rate for an interest period or calculation period is set at the start of that period, with payment due at the end. As such, this provides certainty of funding costs to assist cashflow management. Also, LIBOR embeds a credit premium (it implies bank credit risk) and a liquidity premium (it includes a premium for longer dated funds).

In contrast, the nominated ARRs are mostly backward-looking overnight rates. They are designed to be near risk-free, with no premium for term. These differences have implications for how interest and other payments based on ARRs are calculated relative to LIBOR based transactions and products.

The transition of existing LIBOR based contracts to contracts referencing ARRs may involve the payment of a spread adjustment and may impact the operation of certain financial covenants. There may also be cash-flow and hedge accounting impacts if a mismatch arises on the transition between a loan and a related derivative.