As most people know, the end of LIBOR is coming – its use is set to be phased out by 2021. With diverse applications ranging from municipal bonds to credit cards, LIBOR is the most widely used benchmark for short term interest rates in the world with an estimated notional amount of $2 trillion. So why does it need replacing?
LIBOR is not based on actual transactions, but on banks’ estimates of the cost to borrow from other banks, making the process vulnerable to manipulation. Beginning in 2012, banks have paid billions of dollars in fines for manipulating LIBOR data as far back as 1991. This was done to increase internal profitability and project enhanced creditworthiness.
Unlike LIBOR’s successor, the Secured Overnight Financing Rate “SOFR”, is based on collateralized transactions with trillions of dollars of trading volume compared to LIBOR’s billions. However, SOFR does have some comparable weaknesses namely its short history of data and the fact that there is only one fixing (overnight). Additionally, there are questions around the availability of longer dated SOFR trades being available by 2021.
Currently the market is heading towards a mean/median approach where a spread will be developed based on historical differences between the two indexes. This spread will be incorporated into the existing swap or loan to make the conversion from LIBOR to SOFR. While the concept may make sense, more details will be needed to make an informed decision. As an example, we don’t know how many years of data will be used to come up with the spread. We also don’t know if the spread will be the same for all maturities or if it will be different for, say a 2-year swap versus a 20-year swap.
For the very latest information on the LIBOR transition and potential opportunities, please join Sam Gruer, managing director from Blue Rose Capital Advisors, for a 1-hour webinar entitled “The World is Moving Away from LIBOR – Here is What You Should Know” on March 28, 2019.