The full transition of US banks using Secured Overnight Financing Rate (SOFR) as the reference rate instead of USD LIBOR which has been the reference rate for nearly 40 years. The reason for this shift is mostly explained by the Fed as the transition away from a rate that has been deemed obsolete due to US banks significantly reducing the volume of transactions that support the LIBOR as the reference rate of choice. This is found on the ARRC – a coalition of private market participants convened by the Fed – factsheet released when the Fed did a roadshow on how and why LIBOR is being replaced. Now, before we go into detail on what the ARRC is and how they chose SOFR to be the new reference rate it would be prudent to note that in the late 2000s and early 2010s LIBOR was also a subject of a manipulation scandal by big banks such as Barclays, Citi Group, and JPMorgan & Chase, where these banks were allegedly submitting artificially higher/lower rates for some dubious transaction to tilt the LIBOR in their favor. Now this was only possible because the methodology on how LIBOR is constructed is reliant on the information provided by the banks and that no collusion ever occurred among these member banks that submitted these rates.
Despite how trustworthy those big banks are, the Fed decided to move away from using LIBOR and in 2014 established the Alternative Reference Rate Committee (ARRC) from leading market participants (of which Citi and JPMorgan are members of course) to hunt for a new reference rate, due to LIBORs relatively lower use around this time – go figure. The ARRCs purpose is to objectively compare possible reference rate alternatives to replace the LIBOR such as OBFR, Treasury Bill and Bond Rates, and the ultimate winner SOFR. The criteria of how SOFR was chosen can be seen in the ARRC factsheets for SOFR which I recommend our readers to look up especially if your existing loans will be affected from the transition from LIBOR to SOFR or plan to get lucky enough to qualify for a home loan in the coming years.
Now that SOFR has been crowned the winner of the ARRC tournament, let’s now get into the criticisms of financial institutions/ market participants against SOFR: 1. more volatile than LIBOR, 2. not forward looking, 3. not applicable to all market participants, and 4. transition to SOFR is not urgent. Criticisms 1 and 2 are somewhat linked, as some view SOFR is more susceptible to the volatility of market conditions as SOFR is computed entirely using actual transactions that have occurred and is therefore backward looking.
To counteract criticism 1 the ARRC looked to use the use the analysis of daily averages of SOFR as a means of explaining away the potential volatility as they argue that the growing use of SOFR leads to the averages being more stable, however that analysis should be taken with a grain of salt as Statistics 101 has shown that generally volatility cannot be eliminated by using averages alone. On the other hand, the gap of SOFR not being forward looking is going to be addressed by a different type of SOFR that isn’t published by the Fed but by Chicago Mercantile Exchange Group: the Term SOFR. The key difference between Term SOFR and Daily SOFR/Compound SOFR published by the Fed is that the Term SOFR is determined by future transactions as computed from the wealth of futures and derivatives contracts going through the CME group’s platform, the full methodology of which can be found here: cme-term-sofr-reference-rates-benchmark-methodology.pdf (cmegroup.com), which outlines how the CME group uses their futures transaction data to build the term structure for SOFR. This leads to criticism number 3, the SOFR is not applicable to all market participants as the Secured in SOFR implies, this shouldn’t really apply to Unsecured Loans, which leads to the ARRC’s response of this criticism to be: banks should start using SOFR so they can build their own term structures or you know, don’t use SOFR. As the ARRC’s guidance on the alternative rates to be used is considered to just be recommendations and financial institutions in the US can opt to use other alternatives to LIBOR as long as they’re considered/proven to be robust – whatever that means. Given that, even though that the SOFR is only recommended to be the base reference rate, most financial institutions will follow as big banks such as JPMorgan & Chase and CitiGroup in the US have already released statements on their websites on what their clients should expect (and inspect) during the transition from LIBOR to SOFR, and more often than not the smaller financial institutions will follow the big boys, whom were unironically involved in the LIBOR scandal that happened before the Fed decided to move away from it. The last criticism on SOFR, which is urgency, is the only criticism objectively answered by ARRC, since despite the expected extension due to the COVID-19 pandemic the USD LIBOR bank panel has ceased to convene starting 30 June 2023.
Even with those criticisms, the SOFR as LIBOR’s substitute is a done deal. So those with loans and other financial instruments tied to either LIBOR or SOFR as of this writing or those looking to avail of such financial instruments, I suggest you look into how the SOFR is determined especially the Term SOFR as these will be the new benchmarks used on financial instruments, and if it is not – you should ask your bank if their alternative is robust. Since at the end of the day, if you found those additional credit risk spreads that are not accounted for in SOFR tacked on by your bank to be unreasonable, then you can use the available benchmarks to guide your decision if the cost of borrowing is worth it.