Laurence Mutkin, honorary senior visiting fellow at Cass
As time marches on toward the likely demise of Libor at
end-2021 (if not before), many people are waking up to the
significant challenges surrounding the transition to the rate's
successor. In the US the successor rate, chosen by a private
sector group, the Alternative Reference Rates Committee (ARRC)
under the auspices of the Federal Reserve, is an average of
overnight rates secured on US government collateral: the
secured overnight financing rate (SOFR).
At first glance, SOFR looks less suitable than Libor to be
the bedrock reference rate for the great spectrum of interest
rates in the US economy – from derivatives contracts
to floating-rate notes, corporate loans to retail unsecured and
SOFR is a lending rate secured against the strongest
possible collateral – which is less relevant to most
real economy transactions, because they involve credit risk. It
is also an overnight rate, which makes it more volatile than a
term rate like three-month Libor and creates difficulties in
the calculation and payment of interest, because the term
interest cost of SOFR can be known only in retrospect.
Some market participants have suggested that it would be
better to have multiple rates fulfilling different roles, given
SOFR's limited scope. But the benefits of moving to SOFR, whose
credibility and integrity as a financial benchmark come from
being rooted in a massively deep and liquid market, and which
complies with the principles for financial benchmarks
promulgated by Iosco, far outweigh all of these drawbacks
– which are, in reality, smaller than they may seem.
Unsurprisingly, the ARRC has been working to address them, as
set out in its paced transition plan.
Wholesale and derivatives markets constitute far and away
the majority of Libor-referencing contracts. These are
surprisingly easy to transition, because they tend to be:
defined by standardised contracts; traded on only a few venues;
overseen by the same regulators; and between highly
sophisticated entities, which have the technology in place to
handle real-time calculations of margin and interest, and to
deal with the fallback mechanisms being put in place to permit
a transition from Libor to SOFR-referencing contracts.
At first glance, SOFR looks less suitable than Libor to
be the bedrock reference rate
Things get trickier as one moves towards cash and retail
markets. One knotty problem is that while Libor reflects credit
risk, SOFR doesn't. That means that in a banking crisis
– where banks' cost of borrowing rises – the
rates at which they lend, if tied to SOFR, will –
perversely – fall (because in a crisis, US Treasury
collateral becomes more sought after).
To address this issue, 10 large US regional banks have
proposed the creation of a dynamic credit spread index to
combine with SOFR, to create a benchmark lending rate which
incorporates changing credit conditions. Both the ARRC and
several international regulators have been cool to the idea. A
fundamental drawback is that a banking crisis is practically
defined as "when credit transactions become difficult to do".
This means that a banking crisis is exactly the moment that an
index based on credit transactions would lose its credibility
and usefulness as a benchmark.
It's also worth remembering that the behaviour of Libor
during the last financial crisis certainly didn't do the job of
protecting the banking system. The likely truth is that no
benchmark index can. That's why capital requirements and many
other regulations were introduced.
Indeed, it may be that allowing a credit component in a
benchmark for bank lending actually increases risk and moral
hazard by making banks think they are better protected from
But what about incumbency and familiarity? Obviously,
Libor's incumbency developed over time: before 1986 it did not
exist. Prior to that, the discount rate was commonly quoted.
People will get used to SOFR, but the Fed could do two things
to help the transition. Its review of the conduct of monetary
policy, currently underway, is the obvious vehicle.
The Fed should start officially targeting SOFR, rather than
the Fed funds rate (the present targeted rate), for three
reasons. Firstly: the Fed's intervention tools are secured
borrowing and lending, which affect SOFR directly, whereas Fed
funds, being unsecured, is something the Fed cannot directly
influence: which makes it a strange thing to target.
Secondly, SOFR reflects a much larger and more significant
market (over $800 billion per day) than Fed funds (less than
$80 billion per day). The Fed's target should be the main
event, not the sideshow.
Thirdly, by adopting SOFR as its target rate, the Fed would
give a great boost to public knowledge and acceptance of SOFR
as a benchmark.
Another thing which might help the swifter adoption of SOFR
could be to change its name to something people can understand
– or at least know how to pronounce. How about 'US
Richard Sandor, lecturer in law and economics at the
University of Chicago Law School and chairman and CEO of the
American Financial Exchange
Economics teaches that it's best to have choices. So
instead of asking which benchmark will replace scandal-ridden
Libor, a better question is which benchmarks will replace
Libor can no longer be in the mix. Don't wait until 2021.
The sooner we get rid of the poll of banks, the better. The
post-Libor landscape offers a world of better options for
lenders, including multiple benchmarks, transparency,
efficiency, lower costs, and greater innovation.
Having multiple benchmarks will enhance market efficiency
and drive down transaction costs. In the US, we are seeing
growing adoption of the Federal Reserve's secured overnight
financing rate, or SOFR, which is derived from borrowing and
lending activity using treasuries as collateral.
An additional rate is Ameribor, short for American interbank
offered rate, which is based on overnight unsecured lending on
the American Financial Exchange (AFX). Both benchmarks are
transparent and regulated and offer capital market participants
a choice of secured, in SOFR's case, and unsecured, in
Ameribor's case, options.
Multiple rates will also lead to greater innovation. AFX
connects borrowers and lenders across the US, creating, for the
first time, a national market for unsecured lending. AFX now
has its data on the blockchain, a first-of-its-kind initiative
to provide greater transparency to market participants,
regulators and academics.
Unlike other markets that only provide time, quantity and
price transaction information, AFX now has records with
additional data fields related to each transaction. This
additional data includes: the entire order book at the time of
each transaction; geographical region of the counterparties to
each transaction; and detailed counterparty information such as
credit rating, type of institution and detailed financial
metrics for each counterparty.
The world after Libor will provide many more options to
lending institutions than before
The world after Libor will provide many more options to
lending institutions than before. One size need not fit all. A
choice of multiple benchmarks will make the lending market more
like other markets, all of which have a plethora of benchmarks
– like the commodity markets (with three different
kinds of wheat for bread, cookies and pasta), oil (Brent, WTI,
Dubai) and equity markets, where there are more indices than
stocks (S&P 500, Dow Jones Industrial Average, Nasdaq, the
Russell 2000, EAFE, and many more).
Bankers and capital markets participants need not fear a
Libor sunset in 2021. There's still time to prepare. But there
is also a lot of work to be done. It is critical that financial
players pay very close attention to, and start reviewing their
loan documents in advance of, the transition.
Lenders need to begin redrafting their commercial and
industrial loan documents to replace Libor with one or more
alternative benchmark reference rates. Similarly, derivatives
dealers and the International Swap and Derivatives Association
need to alter their master service agreements and short-form
trade confirmations to replace Libor with one or more
alternative benchmark reference rates aligned with Iosco
Choice is good and will allow capital market participants
access to a truly representative American rate. All will
benefit from increased transparency as benchmarks reflect
financing activity in real time. The lending markets will be
more diverse, and market efficiency will increase. It's up to