Insight & Analysis

Spectre of SOFR transition looms large

Published: Jun 2022

The transition away from the LIBOR [London Interbank Offered Rate] benchmark has picked up pace, but some are still clinging to USD LIBOR ahead of the final deadline next year. Now is the time to take action and finally move to its alternative, the Secured Overnight Financing Rate (SOFR).

Goldfish jumping from small crowded fish bowl to big, empty one

It’s not like people haven’t had plenty of warning that things were going to change. The scandal-tainted LIBOR benchmark has slowly been phased out, but there are still remnants out there – particularly with the USD LIBOR. Those clinging to the old way of doing things – out of a fear of change, perhaps – could actually be creating more risk in the process. Many industry parties are now urging companies to move to SOFR – USD LIBOR’s alternative – once and for all.

LIBOR was a benchmark for many currencies, and there have been different timelines for phasing out each of them. There were end dates for certain USD tenors, which passed in December 2021. And for the remainder of the USD LIBOR – for overnight, 1, 3, 6 and 12-month tenors – the final deadline is June 2023. The Financial Stability Board has made clear in a statement that firms should have already stopped the use of new USD LIBOR, and they must have plans in place to prepare for its final end.

Rather than being set by a panel of banks who report what they think the rate should be – as was the case with LIBOR, which led to manipulation and an ensuing scandal – the SOFR is calculated based on the actual prices of transactions in the overnight repo market as reported by the Federal Reserve Bank of New York.

Although LIBOR may seem familiar, easy and comfortable, the old way of doing things may actually have the opposite effect. This was the argument of Tal Reback, Director, Credit at KKR Capital Markets, who leads investment company KKR’s LIBOR transition across private equity, credit, capital markets and real estate.

She argued in an opinion piece for the Financial Times last year that US companies should stop using LIBOR now, because the risks are rising for those who cling to its use. She writes that borrowing in LIBOR adds complexity and risk. And Silvia Devulder, Head Legal Romandie in Financial Services for EY, also notes that despite key milestones being reached, the transition isn’t over and market participants need to prepare now for the end of USD LIBOR.

So far most of the focus on the transition has been on the derivatives market. And there the adoption has been progressing at a steady pace. EY notes that at the end of Q1 2022 the adoption of SOFR was gaining momentum, with most of the use being in both the cash and the derivatives markets. According to data from the ISDA-Clarus RFR Adoption Indicator, in May 2022 more than half of USD derivatives were transacted in SOFR.

J.P. Morgan also notes how derivatives have led the LIBOR transition and that SOFR is the dominant benchmark for new transactions in trading and lending markets, with an accompanying shift in liquidity towards SOFR. Ben Kinney, Global Co-Head of Interest Rate Sales, noted in a piece for J.P. Morgan, “In early March, the notional of SOFR swaps traded in the market was higher than that of LIBOR swaps for the first time.”

Also, corporate loans using SOFR are increasing. However, KKR’s Reback notes that because most of the focus has been on the over-the-counter derivatives market, the more complex loan market has been left behind. She quotes figures from the S&P LCD database from October last year that showed only US$9.5bn out of US$154bn of loans have been in SOFR.

For smaller companies that don’t have access to the capital markets, if they continue to use LIBOR there could be a risk as LIBOR liquidity in the coming months is looking less certain. And, also, if companies use contracts that automatically convert to SOFR there could be cash flow, accounting and reporting risks. J.P. Morgan likewise notes how USD LIBOR will continue to decline and states “We urge market participants to assess their remaining USD LIBOR referencing portfolios and have a strategy in place for transition as soon as possible.” In short, the message is that for anyone still clinging to the past, now is the time to change and move to SOFR once and for all.

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