Going for a floating rate loan? Your benchmarks rates might get replaced!
If you’re considering a floating rate loan, it’s important to stay informed about the benchmark rates that determine the interest rates on these loans. The benchmark rates are subject to fluctuations depending on the market they operate in, but what you may not have considered is that the benchmark rates themselves might get replaced. One such benchmark rate, the London Interbank Offered Rate (LIBOR), is set to be replaced by another benchmark called the Secured Overnight Financing Rate (SOFR) in 2023. In this article, we will explore why this change is happening and what it means for borrowers.
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What is LIBOR
LIBOR stands for the London Interbank Offered Rate. It is a benchmark interest rate that represents the average interest rate at which major banks in London are willing to lend to each other in the international interbank market for short-term loans. LIBOR serves as a reference rate for a wide range of financial instruments, such as loans, mortgages, derivatives, and bonds.
LIBOR is calculated and published every business day by the ICE Benchmark Administration (IBA) based on submissions from a panel of major global banks. The panel consists of banks that have a significant presence in the London market and are selected annually. The IBA asks these banks how much they would charge to lend to other banks for various currencies (U.S. dollar, euro, British pound, Japanese yen, and Swiss franc) and different maturities (ranging from overnight to 12 months). The highest and lowest submissions are excluded, and the remaining rates are averaged to determine the LIBOR rate for each currency and maturity.
The most commonly referenced LIBOR rate is the three-month U.S. dollar rate, often referred to as the “current LIBOR rate.” However, there are multiple LIBOR rates calculated for different currencies and maturities, totaling 35 rates published each business day.
LIBOR plays a crucial role in the global financial system as it influences the interest rates for a vast array of financial transactions. Lenders often add a margin to the LIBOR rate to determine the interest rate charged to borrowers. For example, a floating rate loan may be quoted as LIBOR plus a certain percentage, where the LIBOR rate serves as the variable component that fluctuates over time.
It’s worth noting that LIBOR has faced scrutiny and challenges in recent years due to concerns about manipulation. Several major banks were fined for their involvement in manipulating LIBOR rates, leading to calls for reform and the development of alternative benchmark rates, such as the Secured Overnight Financing Rate (SOFR) in the United States.
As a result, efforts are underway to phase out LIBOR by the end of 2021. Various countries and financial institutions are transitioning to alternative benchmark rates to ensure a more reliable and transparent reference for financial transactions.
How is LIBOR calculated?
LIBOR (London Interbank Offered Rate) is calculated on a daily basis by the ICE Benchmark Administration (IBA). Here’s a step-by-step overview of how LIBOR is calculated:
1. Panel Selection: The IBA selects a panel of major global banks that have a significant presence in the London market. The composition of the panel may vary for each currency and maturity.
2. Rate Submissions: Each business day, the panel banks provide their submissions to the IBA. The IBA asks the banks the following question: “At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am?”
3. Trimming: The IBA trims the submissions to exclude the highest and lowest figures. This step aims to remove any potential outliers or extreme rates that could distort the final calculation.
4. Calculation: The remaining submissions are averaged to calculate the LIBOR rate for each currency and maturity. The IBA uses a method called the “trimmed arithmetic mean” to determine the average rate.
5. Publication: Once the rates for each currency and maturity are calculated, the IBA publishes them daily at approximately 11:55 a.m. London time. The published rates are made available to the public and market participants.
It’s important to note that LIBOR rates are forward-looking rates, meaning they reflect the banks’ expectations of borrowing costs over different time periods. For example, the three-month LIBOR rate represents the average interest rate at which banks anticipate borrowing funds from other banks for a three-month period in the future.
The calculation methodology of LIBOR has been subject to criticism and scrutiny in the past. Concerns about potential manipulation led to regulatory investigations and fines imposed on banks involved in misconduct. These incidents highlighted the need for reform and the development of alternative reference rates, such as the Secured Overnight Financing Rate (SOFR), which is based on actual transactions in the U.S. repo market. The transition away from LIBOR to more robust benchmark rates is currently underway.
Why not LIBOR?
The major reason behind introduction of an alternative to LIBOR is the method by which it is calculated. As we have read the ICE asks the major bank the rates that they would charge to derive LIBOR and does not use the actual transacted data due to which it becomes extremely easy for the banks to manipulate LIBORs. In the past Major banks allegedly colluded to manipulate the LIBOR rates. They took traders’ requests into account and submitted artificially low LIBOR rates to keep them at their preferred levels. The intention behind the alleged malpractice was to bump up traders’ profits who were holding positions in LIBOR-based financial securities. Following reporting by the Wall Street Journal in 2008, major global banks, which were on the panels and contributed to the LIBOR determination process, faced regulatory scrutiny. It involved investigations by the U.S. Department of Justice. Similar investigations were launched in other parts of the globe including in the U.K. and Europe. Major banks and financial institutions including Barclays, ICAP, Rabobank, Royal Bank of Scotland, UBS, and Deutsche Bank faced heavy fines. Punitive actions were also taken on their employees who were found to be involved in the malpractice. Due to all these past manipulations and the calculation methodologies the LIBOR faces questions to its reliability and there arose a need to find an alternative to LIBOR which is much more transaction based and driven by reliable and accurate data. One more reason behind phasing out LIBOR is that the underlying market that determines LIBOR has stopped having a significant transaction volume. This means LIBOR is often based on the judgement of a panel of banks rather than on robust market data, again impacting its credibility.
What is SOFR?
SOFR stands for Secured Overnight Financing Rate. It is a benchmark interest rate that serves as an alternative to LIBOR (London Interbank Offered Rate). SOFR is specifically designed to be a more reliable and transparent benchmark rate for financial transactions.
Here are some key points about SOFR:
1. Calculation: SOFR is calculated based on actual transactions in the U.S. Treasury repurchase agreement (repo) market. It measures the cost of borrowing cash overnight, collateralized by U.S. Treasury securities. The calculation takes into account a wide range of overnight repo transactions, making it a robust and transaction-based rate.
2. Overnight Rate: Unlike LIBOR, which offers rates for various tenors (such as 1-month, 3-month, etc.), SOFR is an overnight rate. It represents the interest rate on borrowing cash overnight.
3. Risk-Free Rate: SOFR is considered a risk-free rate because it is collateralized by U.S. Treasury securities. These securities are considered highly secure and have minimal credit risk.
4. Transparency and Reliability: SOFR is based on a large volume of actual transactions in the repo market, which adds transparency and reduces the risk of manipulation. The daily transaction volumes underlying SOFR are typically around $1 trillion, providing a solid foundation for its calculation.
5. Alternative Reference Rate Committee (ARRC): The ARRC, established by the Federal Reserve Board and the New York Fed, has recommended SOFR as the preferred alternative to USD LIBOR. The committee aims to facilitate the transition from LIBOR to SOFR in various financial markets.
6. Phasing Out LIBOR: As LIBOR is being phased out by the end of 2021, SOFR is expected to become the primary benchmark rate for a wide range of financial contracts and instruments in the United States.
It’s worth noting that while SOFR is the leading alternative for USD-denominated transactions, other countries are exploring their own benchmark rates as replacements for LIBOR. For example, the United Kingdom has adopted the Sterling Overnight Index Average (SONIA), the European Central Bank (ECB) uses the Euro Short-Term Rate (€STR), and Japan has its Tokyo Overnight Average Rate (TONAR).
How is SOFR calculated?
SOFR (Secured Overnight Financing Rate) is calculated based on the transactions that occur in the U.S. Treasury repurchase agreement (repo) market. Here’s an overview of how SOFR is calculated:
1. Data Collection: The Federal Reserve Bank of New York collects transaction data from various participants in the repo market. These participants include banks, broker-dealers, and other financial institutions.
2. Transaction Types: The data collected primarily focuses on overnight repo transactions. Repo agreements involve the sale of securities (in this case, U.S. Treasury securities) with an agreement to repurchase them at a later date. The transactions are collateralized by these U.S. Treasury securities.
3. Transaction Volume: The Federal Reserve Bank of New York considers a wide range of overnight repo transactions, which ensures a large volume of transactions are included in the calculation. This helps provide a robust and representative rate.
4. Weighted Average: Once the transaction data is collected, the Federal Reserve Bank of New York calculates a volume-weighted average of the overnight repo rates. This means that larger transactions have a greater influence on the calculated rate compared to smaller ones. By taking the weighted average, the calculation reflects the overall market activity.
5. Publication: The calculated SOFR rate is published on a daily basis by the Federal Reserve Bank of New York. It is typically announced around 8:00 a.m. Eastern Time on the following business day.
6. Backward-Looking Rate: SOFR is a backward-looking rate, which means it reflects the rates observed from the previous day’s transactions. This is in contrast to forward-looking rates, which provide rates for future periods. The backward-looking nature of SOFR ensures that it is based on actual transactions rather than being estimated or predicted.
By utilizing actual transactional data from the repo market, SOFR aims to provide a more reliable, transparent, and robust benchmark rate compared to LIBOR, which relied on submissions from banks. The large transaction volumes underlying SOFR contribute to its credibility and reduce the risk of manipulation.
Will LIBOR be replaced by SOFR entirely?
SOFR is likely to be used in the U.S. and the U.K. but other countries are exploring using their own version of a benchmark rate for when LIBOR is phased out. For instance, the United Kingdom chose the Sterling Overnight Index Average (SONIA), an overnight lending rate, as its benchmark for sterling-based contracts going forward. The European Central Bank (ECB), on the other hand, opted to use the Euro Overnight Index Average (EONIA), which is based on unsecured overnight loans, while Japan will apply its own rate, called the Tokyo overnight average rate (TONAR)
A Brief Summary of LIBOR and SOFR
|
LIBOR |
SOFR |
| Bank to bank lending rate | Risk free rate |
| Based on submissions by the banks involving judgements | Totally transaction based. |
| $ 500 million of daily trading on 3-month wholesale funding market. (2021) | Over $1 trillion of daily actual transaction in the overnight repo market. (2021) |
| Forward looking and anticipated term structure | Overnight, backward looking and transaction based. |
| Denominated in USD, GBP, EUR, JYP and CHF. | Denominated in USD (Other countries are looking for their own benchmarks) |
In summary, the replacement of LIBOR with alternative benchmark rates like SOFR is driven by concerns over manipulation and the need for more reliable and transaction-based rates. SOFR, being based on actual transactional data, provides a more transparent and robust benchmark for floating rate loans. While other countries may adopt their own benchmark rates, the shift away from LIBOR aims to enhance the integrity and accuracy of benchmark rates in the global financial system. As a borrower considering a floating rate loan, it’s essential to stay informed about these changes and understand how they may affect your loan’s interest rates.
Author Bio
Very well explained & Much needed of the hour Article.
Thanks…