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Head-to-head: Is SOFR alone enough for the US industry as a Libor replacement?

Is it problematic to divide liquidity between different rates? American Financial Exchange CEO Richard Sandor and Cass Business School honorary senior visiting fellow Laurence Mutkin make their case


Laurence Mutkin, honorary senior visiting fellow at Cass Business School

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 secured lending.

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 banking crises.

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 Secured Funds'?


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 it.

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 benchmarks.

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 you.

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