Interest Rates: LIBOR, SOFR, and Other Alternatives

Few interest rates have been more widely used and adopted than the London Interbank Offered Rate (LIBOR). However, as evidenced in 2012, LIBOR has some fundamental flaws which have allowed for wide-scale manipulation [1]. Quoted in five currencies and seven maturities, the proliferation of LIBOR rates spread through the financial system and currently underly over $200 trillion in financial contracts, roughly equivalent to 10 times US GDP. In 2014, the Alternative Reference Rates Committee (ARRC) was convened to determine an alternative reference rate for use in cash and derivative markets. The newly formed Secured Overnight Financing Rate (SOFR) is slated to replace US LIBOR and features the following distinct differences from LIBOR [2].

SOFR rates are derived based on the US Treasury repo market, which is generally considered to be active, sufficiently deep, and well-defined. Because the SOFR rate is directly based on observable market transactions in the repo market, SOFR is presumably more transparent, and is not based on estimates or models. These attributes would make the SOFR rate extremely difficult to manipulate. The ARRC believes that due to the stability of the underlying market at the time of the global financial crisis, the SOFR rate can be sustainably produced under a wide range of financial market conditions [3].

Outside the US, there have been similar developments in creating other alternative risk-free rates internationally, including:

• Sterling Overnight Index Average (SONIA) in the UK
• Euro Short-Term Rate (ESTER) in the EU
• Swiss Average Overnight Rate (SARON) in Switzerland
• Tokyo Overnight Average Rate (TONAR) in Japan

Each of these rates feature both similarities and differences to the SOFR rate, and are currently available (with the exception of the ESTER rate which will be live October 1, 2019). One unifying feature of all these rates, with the exception of SARON, is eligible transactions are no longer limited to interbank transactions only, and include rates paid by banks to non-bank lenders.

One of the fundamental differences between LIBOR and SOFR is that LIBOR utilizes a forward-looking term structure, whereas SOFR will rely upon an implicit use of an average of the overnight rate. This backward-looking average should have the effect of smoothing out any idiosyncratic daily volatility, but rates will also likely not respond as quickly to large interest rate changes such as a Federal Reserve change in interest rate. Because SOFR rates are applied in arrears and averaged, this also means interest payments will not be known until shortly before the actual pay date. To account for this, there are different models being put into place which include incorporating payment delays, lockout periods, and lookback periods. These different models each enable payments to be known prior to payment, though still represent a dramatic change compared to LIBOR when exact payments will be known months in advance. Currently, a forward-looking term structure for SOFR rates does not exist, though the AARC has set a goal of producing a forward-looking term structure as SOFR derivative markets develop [4].

Through all of these changes, Clearwater has been actively engaged in research and dialogue in handling this transition, including internal development projects, acquiring required data contracts, and developing new methodologies to ensure accurate calculation and reconciliation based on these new rates.

[1] https://www.cfr.org/background…

[2] https://www.newyorkfed.org/arrc/sofr-transition; https://www.newyorkfed.org/med…

[3] https://www.newyorkfed.org/med…

[4] https://www.newyorkfed.org/med…

This material is for informational purposes only. The information we provide is from sources Clearwater Analytics considers reliable, but Clearwater Analytics provides no warranties regarding the accuracy of the information. Further, nothing herein should be construed as legal, financial, or tax advice, and any questions regarding the intended recipient’s individual circumstances should be addressed to that recipient’s lawyer and/or accountant.