LIBOR Replacement Begins Publication

On April 3, 2018, the New York Federal Reserve Bank began publishing the Secured Overnight Financing Rate (SOFR), a daily, broad Treasury repo financing rate that the New York Federal Reserve Bank’s Alternative Reference Rate Committee (ARRC) recommended the adoption of last year as the alternative to LIBOR. While LIBOR has relied on input from bankers, SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities, regardless of the motivation of the cash providers participating in the trades. The SOFR includes all trades in the Broad General Collateral Rate plus bilateral Treasury repurchase agreement (repo) transactions cleared through the Delivery-versus-Payment (DVP) service offered by the Fixed Income Clearing Corporation (FICC), which is filtered to remove a portion of transactions considered “specials.”¹ The SOFR is calculated as a volume-weighted median of transaction-level tri-party repo data collected from the Bank of New York Mellon (BNYM) as well as GCF Repo transaction data and data on bilateral Treasury repo transactions cleared through FICC's DVP service, which are obtained from DTCC Solutions LLC, an affiliate of the Depository Trust & Clearing Corporation. Each business day, the New York Fed publishes the SOFR on the New York Fed website at approximately 8:00 a.m. 

In its latest report, the ARRC acknowledges that the transition to SOFR will be difficult, given the volume of legacy contracts that reference LIBOR and do not have a fallback for its cessation. The ARRC observed that loan documentation typically implies that if LIBOR quotes are not published, the loan converts to an alternative base rate, such as the prime rate. However, because the prime rate is typically well above LIBOR, this would result in an unplanned and significant increase in borrowing costs.

The ARRC convened a working group to better understand the difficulties involved with the transition to SOFR and to conduct research into common forms of LIBOR-related contract language in the lending market. Working-group members noted that loan contract language has begun to more robustly address economically appropriate fallbacks to LIBOR. They also observed that there has been a movement by some market participants away from requiring unanimous consent of lenders to change the reference rate in syndicated loans.

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The new report also provides for a paced transition plan to create a baseline level of liquidity for derivatives contracts referencing SOFR. The ARRC acknowledged that “end users cannot be expected to choose or transition cash products to a benchmark that does not have at least a threshold level of liquidity in derivatives markets.” The report lays out a six-step transition plan, which concludes at the end of 2021 with the creation of a term reference rate based on SOFR derivatives. The intermediate steps are:

• ARRC members will input infrastructure for overnight index swaps (OIS) and/or futures trading in SOFR in 2018.
  
  
• Trading in futures and/or bilateral, uncleared OIS that reference SOFR will take place by end of 2018.
  
  
• In 2019, trading will begin in cleared OIS that reference SOFR in the current effective federal funds rate (EFFR) price alignment interest (PAI) environment.
  
  
• In 2020, central counterparties will begin allowing market participants to choose between clearing new or modified swap contracts in the current PAI/discounting environment or in one that uses SOFR for PAI and discounting.
  
  
• In 2021, central counterparties will no longer accept new swap contracts for clearing with EFFR as PAI and discounting.

The overarching goal of the paced transition plan is to progressively build the liquidity required to support the transition to and issuance of contracts referencing SOFR.

¹ “Specials” are repos for specific-issue collateral, which take place at cash-lending rates below those for general collateral repos because cash providers are willing to accept a lesser return on their cash in order to obtain a particular security.