This article explains what LIBOR is; the reason LIBOR is coming to an end; the alternative reference rate that likely will replace LIBOR; and the steps the market, and Wells Fargo, are taking to prepare for this transition. For more information or to connect with a Wells Fargo Auto Commercial representative, contact us at www.wellsfargo.com/sofrauto.
Switching gears from LIBOR to SOFR
The world’s most important interest rate may disappear in as early as two years’ time, at the end of 2021. The London Interbank Offered Rate (LIBOR), is one of the most recognizable and dominant rates in the world, underpinning tens of millions of financial contracts worth more than $400 trillion dollars worldwide.1 But LIBOR, as it exists today, is no longer reflective of actual transactions in the market. Regulators have identified significant structural risks with LIBOR and have called on the market to transition away from LIBOR to alternative reference rates.
LIBOR emerged as a benchmark interest rate in the 1980s, representing the cost of borrowing between banks. Its adoption spread quickly as market participants saw the value in a common base rate to underpin and standardize private transactions. As a result, LIBOR is included by name in standard contract language for a wide range of financial products including corporate loans, derivatives, and securitizations as well as consumer products such as residential mortgages and student loans. A contract for a corporate loan such as a dealership flooring line or real estate loan, for example, may state the monthly interest rate as LIBOR plus 2.00%. Thus, as LIBOR changes each month, so does the cost of borrowing.
In its simplest term, LIBOR is a number calculated based on the estimated cost of borrowing between banks. A panel of global banks submit their LIBOR estimates each day, which are then averaged and published to the market.
LIBOR is calculated for five different currencies (the U.S. dollar, the Swiss franc, the euro, the pound sterling, and the Japanese yen) across seven different maturities (overnight, one-month, two-month, three-month, six-month, and twelve-month). This results in 35 LIBORs (one for each currency and maturity combination) calculated and published each day.
Each currency LIBOR has a different panel of banks submitting estimates of their borrowing costs, ranging in size from 11 to 16 banks. Wells Fargo is not, and has never been, a panel bank.
While LIBOR has been a long-established, global benchmark for interest rates, LIBOR’s credibility declined over the past decade. Concerns over LIBOR first arose during the financial crisis of 2008 when the rate behaved in unpredictable and volatile ways that were inconsistent with other market rates and prices. Regulators conducted a very public series of investigations and discovered market-manipulation schemes amongst certain panel banks, resulting in large fines and penalties.
LIBOR’s credibility was further damaged because banks stopped lending to each other in the unsecured interbank market that underpins LIBOR. This meant that LIBOR did not always reflect actual extensions of short-term interbank credit and instead reflected judgement-based quotes. As the volume of direct borrowing underpinning LIBOR decreased, LIBOR panel banks relied more upon hypothetical transactions and expert judgment.
Despite regulatory review and implementation of reforms to strengthen the calculation process, regulators around the world called for the end of LIBOR in recognition of its fundamental deficiencies that the world’s most important number was no longer derived from an active and observable market.
The global effort to replace all LIBORs is not simply a U.S. or U.K. effort, but a coordinated, global initiative. International working groups have been established to identify appropriate alternative reference rates and develop a transition strategy for each currency LIBOR. In the US, the Federal Reserve Board and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC), a public/private sector working group that includes Wells Fargo, to explore alternatives to replacing US dollar LIBOR. Wells Fargo is one of two banks that are members of every ARRC working group, including serving as chair for Floating Rate Notes and the content creation sub group. The ARRC officially endorsed the Secured Overnight Financing Rate (SOFR) as the replacement rate for US dollar LIBOR in June 2017 and published the Paced Transition Plan, which identifies key milestones to shift the US dollar LIBOR market to SOFR.
SOFR is a broad measure of the cost of borrowing cash overnight against Treasury securities (also known as the repurchase market). It is a market-driven, secured borrowing rate based on a deep and established lending market. Money market mutual funds, asset managers, securities lenders, and securities dealers, among others, are key participants in the overnight repurchase market. The volumes underlying SOFR (approximately $1 trillion daily) are far larger than the transactions in any other U.S. money market. The Federal Reserve Bank of New York began publishing SOFR in April 2018.
The working groups for the other LIBOR currencies have also identified alternative risk-free reference rates, as shown in the table below. In some jurisdictions, the new alternative reference rate will co-exist alongside other interbank offered rates (IBORs).
|USD LIBOR||Secured Overnight Financing Rate (SOFR)|
|GBP LIBOR||Reformed Sterling Overnight Index Average (SONIA)|
|EURIBOR||Not scheduled to be discontinued|
|Euro LIBOR||Euro Short-term Rate (€STR) or EURIBOR|
|EONIA||Euro Short-term Rate (€STR)|
|CHF LIBOR||Swiss Average Rate Overnight (SARON)|
|JPY LIBOR||Tokyo Overnight Average Rate (TONAR) or TIBOR|
|TIBOR||Not scheduled to be discontinued|
There are several key qualitative differences between SOFR and LIBOR, notably:
- SOFR is a secured rate and LIBOR is unsecured.
- SOFR currently exists only as an overnight rate, whereas LIBOR has seven different forward-looking tenors (overnight, one week, one month, two months, three months, six months, and 12 months).
- SOFR is administered by the Federal Reserve Bank of New York, and LIBOR is administered by a private company, the ICE Benchmark Administration.
SOFR is backed by roughly $1 trillion in daily transactions, whereas LIBOR consists of at most, $500 million in daily transactions.
Choosing SOFR as the go-forward benchmark rate is the easiest part of the process. Actually replacing LIBOR is a highly complex undertaking. It is estimated that 18% of outstanding US dollar LIBOR contracts mature after 2021, which is the earliest date that LIBOR may cease to exist. 3
The most effective way to mitigate LIBOR risk is to refinance into SOFR. However, the SOFR market is still a very young market with $15 trillion in volume since it was first published in April 2018, compared to the $200 trillion US dollar LIBOR market that was developed over a 30-year period. The “plumbing” of the market (technology and systems) is also under development and is a dependency before lenders can begin to reference SOFR. Until the market is able to offer SOFR and other alternative reference rates on a broad basis, an important approach to managing LIBOR risk is to ensure LIBOR contracts contain contractual language that ensures transactions remain effective should LIBOR be discontinued during the term of the contract (fallback language). One of the most critical transition questions for the market is how to facilitate the conversion of existing LIBOR transactions to SOFR from a contractual documentation and economic terms standpoint.
The majority of LIBOR contracts never contemplated LIBOR going away permanently. As a result, the market has developed more robust fallback language for use in LIBOR contracts intended to reduce the risk of serious market disruption upon the discontinuation of LIBOR. The ARRC published fallback language for several non-derivative products in 2019 and the International Swaps and Derivatives Association (ISDA) expects to publish fallback language for derivatives in early 2020.
Unlike prior regulatory changes where the regulators have told the market what to do and when, the LIBOR transition is different. Each LIBOR currency working group is developing its own timeline and implementation plan to transition each currency market to the new alternative reference rates. There is a need for global collaboration; however each market is progressing on different timelines. In the US, there is still a lot of work to be done to develop liquidity in SOFR, update the “plumbing” and operational aspects of using a new rate and address unintended consequences of transitioning to SOFR. For example, there is the need for tax and accounting relief before outstanding LIBOR contracts can be remediated. The ARRC has identified several of these key areas and has requested relief from the official sector and government agencies. While it is anticipated that the required relief will be granted, an absence of certainty would materially hinder the transition work. 4
The key date for the LIBOR transition is the end of 2021. That date is tied to an agreement that the Financial Conduct Authority, the UK regulator of LIBOR, has with the panel banks that requires them to submit LIBOR through the end of 2021. Whether panel banks will continue to voluntarily submit rate estimates after that date is unknown, but the Financial Conduct Authority indicated that even if panel banks continue to do so, LIBOR may not meet regulatory requirements for use.
As we get closer to the end of LIBOR, several key milestones will aid the transition efforts as 2020 and 2021 unfold. Notably, the implementation of fallback language for derivatives and SOFR options trading in Q1 2020, greater adoption of fallbacks for non-derivatives, and the operational and infrastructure work to deliver SOFR loans to the market.
At Wells Fargo, we’re taking steps to ensure our customers have the necessary support throughout this transition. In 2018, Wells Fargo’s Chief Financial Officer established a dedicated, enterprise-level office called the Libor Transition Office, to manage the critical transition risks to the company and our customers. The LIBOR Transition Office is comprised of subject matter experts in derivatives, credit, cash products and consumer products as well as project management, finance, risk, communications and all other major disciplines that are necessary for a successful transition. The goal is to ensure our customers are not only informed with the right information, but are also equipped with the right support for a seamless transition.
For more information or to connect with a Wells Fargo Auto Commercial representative, contact us at www.wellsfargo.com/sofrauto.
1 ISDA Global Benchmark Survey 2018 Transition Roadmap; Alternative Reference Rates Committee.
2 EONIA was recalibrated on October 2, 2019 to be €STR + 8.5bps. It will be published in this manner until January 3, 2022, at which point it will be discontinued.
3ARRC Second Report. www.newyorkfed.org/medialibrary/Microsites/arrc/files/2018/ARRC-Second-report