Current market volatility has exposed shortcomings in the Secured Overnight Financing Rate (“SOFR”), and perhaps has extended the London Interbank Offered Rate (“LIBOR”)’s existence. But before we get into that, a little background is required.
Regulators on both sides of the Atlantic have spent the better part of three years trying to kill LIBOR. LIBOR has been a key reference rate for negotiating and settling hundreds of trillions of dollars in financial contracts in the cash and derivatives markets. However, beginning in 2012, an international investigation into LIBOR revealed a widespread scheme by multiple banks involved in the rate setting process to manipulate the LIBOR rate going as far back as 2003. It was determined that a more transaction-based benchmark was needed to deliver transparency and validity to the large amount of impacted transactions, and the benchmark chosen in the US to do this is SOFR.
Both SOFR and LIBOR reflect short-term borrowing costs, but key differences exist between the two benchmarks. SOFR is based on hundreds of billions of dollars in transactions in the US overnight repurchase (“repo”) market and represents the cost of borrowing cash overnight that is collateralized by US Treasury securities. Because the repos used for setting SOFR are collateralized with US Treasury securities, SOFR is deemed a risk-free rate. 3-month SOFR is constructed daily by the Federal Reserve (the “Fed”) by averaging the previous 90 days of daily SOFR rates. LIBOR is derived from estimates submitted by a select group of the world’s largest banks. Each bank estimates what it would be charged if it were to borrow from other banks.
The Fed intended to use SOFR as the benchmark for its $600 billion Main Street Lending Program, which will buy debt from small and midsize businesses as part of their coronavirus stimulus activity. However, the Fed has since scrapped plans to use SOFR, and reverted to LIBOR after receiving significant opposition from some of the country’s biggest banks. The opposition to SOFR is in part due to uncertainty on how the benchmark performs relative to LIBOR. The chart below plots 3-month LIBOR and 3-month SOFR.
At the inception of SOFR in July 2018 and the subsequent 12 months, there was a positive spread in 3-month LIBOR relative to 3-month SOFR. This is what one would expect being that LIBOR represents an unsecured loan between banks compared to SOFR which, again, is derived from repos backed by US Treasury securities.
In late 2018, 3-month LIBOR began to decline while 3-month SOFR continued an upward trend. 3-month SOFR eventually began to follow 3-month LIBOR to lower levels, albeit with a lag. SOFR’s lag in following LIBOR's reversal can be attributed to the ninety-day averaging effect inherent in 3-month SOFR. By late 2019, 3-month SOFR again went lower than 3-month LIBOR resuming the expected spread between LIBOR and SOFR.
What has been most alarming to market participants is how the two benchmarks have moved relative to one another since the onset of COVID-19 and the shutdown of the economy. The two benchmarks have moved in dramatically different directions in a short period of time. In highly volatile markets like we are currently in, 3-month SOFR has experienced very little parity, if any, with 3-month LIBOR. During this timeframe the correlation between SOFR and LIBOR has been just 39% compared to over 60% prior to COVID-19 and the shuttering of the US economy.
Transitioning from LIBOR to SOFR was already going to be a monumental task. The challenge in finding an orderly transition from LIBOR to SOFR has become even more evident in the current turbulent market. This has caused the Fed to back-off from using SOFR in its $600 billion Main Street Lending Program; it has highlighted for market participants the pitfalls of SOFR in a market rife with volatility, which is breathing life back into LIBOR. While nothing has been announced by the regulators overseeing the transition from LIBOR to SOFR, the 2021 transition deadline may be in jeopardy. Those that are active borrowers or investors relying on financial instruments that are tied to short-term interest rates will want to consult their advisors, and consider carefully, what benchmarks they do and/or will have exposure to – and the impact of those exposures.