Transition from LIBOR
The transition from LIBOR represented one of the most complicated changes in financial market infrastructure ever required. The pervasive use of LIBOR across all market segments made the transition particularly complex, since the disruption or cessation of LIBOR posed significant risks to financial stability overall and to individual firms.
LIBOR’s inadequacies first came to light in the wake of the global financial crisis. Most notably, LIBOR was not anchored in actual market activity, which left it vulnerable to manipulation. The ARRC was later formed in 2014 in response to Financial Stability Board and Financial Stability Oversight Council recommendations to address USD LIBOR risks. The ARRC reviewed the full range of markets that could be used to form an alternative to USD LIBOR and developed a plan (the Paced Transition Plan) to encourage liquidity in a chosen alternative. In 2017, following consultation, the ARRC unanimously selected SOFR as its recommended alternative to USD LIBOR.
The announcement by LIBOR’s regulator in 2017 that it could not guarantee LIBOR’s existence after 2021 accelerated the pace of the ARRC’s work. This work included the development of fallback contract language to ensure USD LIBOR-based contacts would remain effective even if LIBOR became unusable; efforts around legislation to minimize risks associated with contracts that could not be amended; as well as the recommendation of Term SOFR and development of its recommended Scope of Use.
In November 2020, following the announcement of the formal end date for representative USD LIBOR, U.S. banking regulators issued guidance noting that supervised entities should stop new use of USD LIBOR as of December 31, 2021. June 30, 2023 then marked the cessation of all USD LIBOR panel settings—the final major step in the transition. Today, SOFR is the dominant U.S. dollar interest rate benchmark.
Given that the end of LIBOR has now been successfully resolved, some may come to underestimate how difficult it was to achieve, and therefore may underestimate the importance of avoiding the types of mistakes made with LIBOR going forward.
Although successful, the transition involved billions of dollars, millions of hours of work by the private sector, active involvement by the U.S. official sector, and even legislation by Congress. The ARRC’s Closing Report therefore emphasizes that market participants should seek to avoid the mistakes that were made with LIBOR and outlines three key areas firms should focus on going forward to maintain robust reference rates. Those areas include (a) active review of any reference rates that firms may consider using, (b) appropriate fallback language for any contractual use of reference rates, and (c) limiting use of Term SOFR in line with the ARRC’s recommended scope of use.
As noted in the report, the New York Fed plans to launch a new sponsored group in 2024 to promote the integrity, efficiency, and resiliency in use of reference rates and to promote the ARRC’s critical best practice recommendations.
See the Closing Report for more on these priorities and a deeper history of the transition and the ARRC.
About SOFR (Secured Overnight Financing Rate)
In 2017, the ARRC selected SOFR as the rate that represents best practice for use in certain new USD derivatives and other financial contracts, representing the ARRC's preferred alternative to USD LIBOR. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities in the repurchase agreement (repo) market. This rate is robust, is not at risk of cessation, and it meets international standards. It is produced by the New York Fed in cooperation with the Office of Financial Research. The New York Fed publishes SOFR each business day at approximately 8:00 a.m Eastern Time.
SOFR is a much more resilient rate than LIBOR was because of how it is produced and the depth and liquidity of the markets that underlie it. As an overnight secured rate, SOFR better reflects the way financial institutions fund themselves today. The transaction volumes underlying SOFR regularly are over $1 trillion in daily volumes. The volumes underlying SOFR are far larger than the transactions in any other U.S. money market. This makes it a transparent rate that is representative of the market across a broad range of market participants and protects it from attempts at manipulation. Also, the fact that it’s derived from the U.S. Treasury repo market means that, unlike LIBOR, it’s not at risk of disappearing.
In order to help explain how market participants can use SOFR in cash products, the ARRC released A User’s Guide to SOFR. This paper builds on the ARRC’s work developing the Paced Transition Plan and addresses a range of topics, including differences between using simple or compound averages of SOFR and differences between calculating payments using in arrears or in advance conventions. Also, in cooperation with the Treasury Department's Office of Financial Research, the New York Fed publishes three daily compounded averages of SOFR in addition to a daily index that allows for the calculation of compounded average rates over custom time periods: the "SOFR Index".
While the ARRC recommended use of SOFR for all products, it also recognized that use of overnight SOFR could be difficult for legacy LIBOR cash products and some business loans. The ARRC therefore recognized use of CME Group's forward-looking SOFR term rates, but only for a limited scope of use that it believed to be consistent with financial stability. This was namely for use in transitioning legacy cash products, and for new use in business loans that would otherwise have difficulty transitioning to overnight SOFR and associated derivatives hedging and securitizations.
Market adoption and use of SOFR has been robust across a broad range of products.
Paced Transition Plan
The Paced Transition Plan below included specific steps and timelines designed to encourage voluntary adoption of SOFR. The timeline for the Paced Transition Plan is shown below.1
- Anticipated completion: 2018 H2
- Completed 2018 H1
2. Trading begins in futures and/or bilateral, uncleared, OIS that reference SOFR.
- Anticipated completion: by end 2018
- Completed May 2018 (CME Group launched 1-month and 3-month SOFR futures contracts on May 7, 2018)
3. Trading begins in cleared OIS that reference SOFR in the current (EFFR) PAI and discounting environment.
- Anticipated completion: 2019 Q1
- Completed July 2018 (LCH cleared its first interest rate swap referencing SOFR on July 18, 2018)
- Anticipated completion: 2021 Q2
- Completed as of close of business on October 16, 2020
- Formally recommended the CME SOFR Term Rates on July 29, 2021
1 In the original formulation of the ARRC’s Paced Transition Plan set out in the ARRC’s 2017 Second Report, there had been six steps, with a Step 4 that involved CCPs providing a choice between SOFR and EFFR PAI and discounting environments for new trades (by 2020 Q1), and a Step 5 in which the CCPs would move to only offer a SOFR PAI and discounting environment for new trades (by 2021 Q2). In consultation with stakeholders, both CME and LCH subsequently determined that it was appropriate to move to the model outlined in the current Step 4, involving an immediate switchover from EFFR to SOFR PAI and discounting in a single step for both cleared new trades and legacy instruments in October 2020.
The original formulation of the Paced Transition Plan also had stated that the goal for the creation of a term reference rate was anticipated by the end of 2021. In line with the ARRC’s 2020 Objectives, this was since adjusted to note that the goal for completion is in the first half of 2021. The ARRC announced its formal recommendation of the CME SOFR Term Rates in July 2021.