By Brian L. Grabenstein, Head of the LIBOR Transition Office, Wells Fargo, and Benjamin Bonner, Managing Director, Head of the Macro Division, Wells Fargo Securities
The U.S. market is transitioning to the Secured Overnight Financing Rate (SOFR) as an alternative U.S. dollar reference rate to LIBOR. The new rate will affect any organization that trades, lends, or borrows based on U.S. LIBOR today.
Instituting a replacement for U.S. LIBOR is a regulatory priority. The Alternative Reference Rates Committee (ARRC) is an inclusive group of market participants under regulatory guidance, particularly the Federal Reserve. ARRC has selected SOFR as its recommended alternative to U.S. LIBOR and established a transition plan to build a market structure and critical mass of liquidity for use as a new standard.1
Why the shift to SOFR
Post-financial-crisis legislation led to a significant change in how banks fund themselves, including a reduction in short-term funding through the unsecured bank-to-bank transaction marketplace. This reduction in interbank transactions is a key impetus for finding a U.S. LIBOR alternative, since U.S. LIBOR’s soundness relies on an active marketplace.
Within the shrinking interbank market, U.S. LIBOR is a floating, unsecured rate determined by the expert judgment of, now, a limited number of participants and relatively few transactions.
The use of SOFR shifts the rate-setting process from a subjective judgment of its participants to an objective methodology supported by robust transaction volume.
- SOFR is a broad measure of the cost of borrowing cash overnight, on a secured basis.
- More than $700 billion in daily transaction volume underpins SOFR.
- The Federal Reserve publishes the rate daily.
In light of regulatory expectations, the market anticipates a relatively quick transition to SOFR. The Paced Transition Plan (PDF) developed by ARRC (PDF p. 18), lays out the process for building market structure and liquidity.
- Step 1. A first step is the adoption of SOFR by the derivatives market, which accounts for the largest number of contracts underpinned by U.S. LIBOR. Futures trading is underway, volume is growing, and trading will expand to swaps and other instruments.
- Step 2. Once there’s sufficient liquidity in derivatives trading referencing SOFR, the next step will be to extend the use of SOFR beyond overnight to longer durations of up to one year. This will allow for development of a term SOFR to facilitate the transition to SOFR for non-derivatives cash products such as loans and bonds.
U.S. LIBOR is woven deeply into the U.S. economy due to its wide use as a benchmark, index, or reference rate for debt and derivative instruments. Therefore, the shift to SOFR will touch all market segments and asset classes, including corporate, middle market, commercial real estate, retail mortgages, credit cards, auto and consumer loans, derivatives, and securitized assets.
Furthermore, with the increase in SOFR referencing products and decline in use of U.S. LIBOR, there’s a continuing risk of discontinuity or even cessation in the production of U.S. LIBOR.
Key ways to prepare for market change
- Understand SOFR is the new rate. The market is moving away from U.S. LIBOR. SOFR is an accurate, transparent U.S. LIBOR alternative that’s gaining market liquidity.
- Conduct an impact assessment. Organizations should analyze their exposure to U.S. LIBOR.
- Financial institutions: Consider any required systems enhancements, new products approvals, rate modeling, and risk management to support SOFR-based activity and potential cessation in the production of U.S. LIBOR.
- Companies: Assess potential effects on future borrowing costs. Increasingly expect to see contractual provisions in borrowing agreements referring to SOFR, plus any adjustment spread, in the event U.S. LIBOR becomes unavailable.
- Keep abreast of developments. Abundant resources are available to provide additional background on what’s happening and why. Many trade associations are members of ARRC and can be a good source of information. In addition, the following links may be helpful:
For more information, contact your Wells Fargo representative or fill out the Contact Us form on this site.
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