Years before the British expect to phase out Libor, the London Interbank Offered Rate that serves as a benchmark to price trillions of dollars’ worth of loans and derivatives globally, the Federal Reserve Bank of New York has introduced a substitute.
It’s called the Secured Overnight Financing Rate, or SOFR, and it’s intended for use as an “alternative to U.S. dollar Libor for use in certain new U.S. dollar derivatives and other financial contracts,” according to the New York Fed.
The expectation is that SOFR will eventually replace Libor, which has been used as a benchmark for borrowing rates on variable-rate mortgages, student loans and credit cards, subject to an additional spread. A loan, for example, would charge borrowers Libor plus 1% or Libor plus 50 basis points.
Though Libor was widely accepted by lenders and borrowers alike for years, it was actually set by a group of bankers in London reporting the average of estimated interest rate banks would be charged to borrow from each other on loans of different maturities and currencies.
In 2012, investigations by regulators in Europe and the U.S., prompted by a series of articles in The Wall Street Journal in 2008, found that several bankers were manipulating Libor rates, costing billions in overpayments by borrowers and ultimately billions in fines for several banks.
The new SOFR, unlike Libor, is based on actual transactions in a deep and liquid market — the U.S. Treasury market, according to the New York Fed. Originally developed by the Alternative Reference Rate Committee (ARRC), it’s designed to initially work alongside Libor, but regulators reportedly hope it will eventually become the benchmark for loans and derivatives.
The New York Fed’s publication of the SOFR, which began Tuesday, is the first step in that process. On May 7, the CME Group is expected to begin trading futures based on SOFR, pending regulatory review.
In the meantime, the three-month Libor has climbed to its highest level since 2008 due to Fed rate hikes and technical factors related to heavy Treasury bill issuance and the U.S. tax cuts, according to Bloomberg. And the spread between Libor and the Overnight Indexed Swap (OIS) rate in the U.S., based on the federal funds rate, has widened significantly — more than 50 basis points in the first quarter, twice the fed funds hike, notes David Kotok, chief investment officer of Cumberland Advisors.
At the end of the first quarter, three-month Libor was 2.30% — twice its level a year ago.
Kotok is concerned about “the businessmen and women who borrow using Libor” as a reference rate. “Their costs of funds are going up fast. And they are uncertain about future commitments since they know Libor is going away and they don’t know what the market will do to replace it. And they are the ultimate target of Fed policy, for better or worse.”
Asked about SOFR, Kotok notes that “most investors have never heard of ARRC or SOFR, yet both impact their daily lives… There are contracts which specifically say Libor and they pre-exist SOFR. This needs some defined transition.”
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