Historically, USD LIBOR has been based on uncollateralized transactions and taken from a diminishing number of observable transactions. By contrast, SOFR is expected to behave differently because it is based on a larger volume of underlying, secured trades.
Regulators are now pushing the industry to move away from LIBOR, feeling it lacks robustness because expert judgement is too often required in the absence of underlying transactions. There is a risk it becomes unstable if it lingers on after the alternatives are in place and some believe banks may decide to stop quoting LIBOR, once they are no longer required to help set the benchmark after 2021 by the UK’s Financial Conduct Authority.
Trading and issuance are “already happening and building momentum, and given the regulatory stance, we think those things will come together,” says Adam Gilbert, regulatory leader at PwC financial services advisory. “Will there be vestiges of LIBOR that stick around? That’s quite possible but we think it’s the exception.”
While SOFR is based on more than $800 billion of underlying short-term loans every day, trading volumes in products like derivatives, loans and securities indexed to the new SOFR rate are still in their relative infancy. Conversely, LIBOR is the other way around. It’s based on only about $500 million of daily trades but there are an estimated $350 trillion in loans and derivatives linked to it - $150 trillion in Europe and Japan and $200 trillion in the US.
Industry experts say that, with the clock ticking and the transition likely to accelerate soon, market participants with exposure to LIBOR need to get ready. In the US, the Fed-sponsored ARRC group set out a “paced transition plan” to sequence the adoption of SOFR. This contemplates derivatives—both on and off exchange—and the creation of a forward-looking rate for loans, bonds and mortgages.
The Securities and Exchange Commission said in a July 11 statement that it would monitor which risks and exposures companies might need to disclose in relation to the transition and “whether the adoption of a variety of replacement rates for USD LIBOR instead of a dominant successor could limit the effectiveness of all replacement benchmarks.”
In the near term, a key focus will be analyzing areas of exposure to LIBOR not just across trading, but across risk, finance, operations, legal and technology groups. That review involves not just collecting all the physical documentation supporting financial contracts, but also looking across the different types of clients using them.