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News & Events / Blog / Replacing LIBOR: Understanding Your Choices

Replacing LIBOR: Understanding Your Choices

With the end of LIBOR fast approaching, a new era for reference rates dawns and the industry is already making the shift to alternatives, with implications across the finance landscape. Although the U.S. Alternative Reference Rates Committee (ARRC) announced their choice of the secured overnight financing rate (SOFR) as their preferred rate to replace LIBOR as far back as 2017, it isn’t required that banks adopt SOFR, and other rates are starting to gain industry interest, if not traction.

As the incumbent benchmark, LIBOR effectively underpins hundreds of trillions globally in financial products—both directly and indirectly. Because of these high stakes and implications, regulators are urging the adoption of new benchmarks ahead of reforms that will see LIBOR wound down by the end of 2021. But which reference rate is right for your bank? Let’s take a look at the top contenders, their benefits, and their limitations.
 
What do we mean by “alternative reference rate?”
A reference rate is a benchmark interest rate used to determine other interest rates. For example, LIBOR provides an indication of the average rates at which LIBOR panel banks could obtain wholesale, unsecured funding for set periods in particular currencies. Lenders then use this rate to determine interest rates for a variety debt instruments (i.e., mortgages and commercial loans) and financial products (i.e., derivatives).
 
Why do I need to pick, and what’s the difference?
The need for benchmarks to be based on transparent, arms-length transactions has been reinforced by global regulators, including The Financial Stability Board and the International Organization of Securities Commissions. In response, the industry has started to use a variety of alternative reference rates. While several replacement rates are in play in the U.S. market, this tension should be resolved in the coming months. But understanding the rates, and which one is the right one for your bank and clients, is critical when making a decision to move forward considering the economic and operational implications.
 
SOFR
SOFR was designed to be more reliable than LIBOR and impervious to manipulation because it is based on actual rates in short-term cash markets. LIBOR, by contrast, is an “indicative rate” based on the rates banks say they can get. SOFR long ago received the AARC’s endorsement as the preferred replacement for LIBOR. The four SOFR rates in play are:
 
Forward-Looking Term SOFR
A forward-looking term SOFR would have a term curve like LIBOR. This would allow market participants to know their interest rates in advance and, because it is so similar to LIBOR, would be easy to build into systems quickly. However, the development of this rate cannot be guaranteed, so there is a need for one (or more) of the following rates as fallbacks. 


SOFR Rate Compounded in Advance
This rate would be determined by compounding the equivalent number of days for the previous time period. For instance, if a borrower wanted a 30-day SOFR contract, it would use the rate calculated by compounding overnight SOFR for the previous 30 days. The positive is that this rate is known in advance and would be operationalized very quickly, as with term SOFR. The negative is that, for longer contract periods, it could be stale.

SOFR Compounded in Arrears
This rate is determined by compounding SOFR during the interest period. If a borrower wanted a 30-day SOFR loan, the system would compound every day for those 30 days to determine the rate at the end. The positives are that this is the true, exact interest rate on the loan, it is what most other asset classes are using and it is perfectly hedgeable with swaps. The main negatives are that the final compounded rate is not precisely known at the beginning of the interest period, and, moreover, implementing this in loan systems may not be feasible by the transition deadline, thus putting transition at risk.* 
 
Simple Daily SOFR in Arrears
This rate is pulled daily, but it is not compounded. The positives are that this rate is basically the exact rate of interest, it is close to being perfectly hedgeable, and loan systems already can do this with daily LIBOR and Prime, so the operational build is modest. The negative is that the exact rate will not be known until the end of the interest period.*

*These methods will require some look-back adjustments.
 
Credit-Sensitive Rates
Many banks are advocating for credit-sensitive alternatives because a component of their own cost of funds is tied to rates that have a dynamic credit component. As a result, a bank could find itself facing a rising cost of funds while its floating rate lending rates remain static or are falling. In addition, given that SOFR (considered a “risk-free” rate) is an overnight rate based on an active market, it is subject to supply and demand dynamics that can result in volatility (although the ARRC offers various compounding and averaging conventions to address this concern). Additionally, both lenders and borrowers have expressed concern around the lack of SOFR term rates.
 
A number of credit-sensitive benchmarks have been in development or proposed by market participants. Certain of these rates rely on the same data underpinning LIBOR, but each with its own more nuanced methodology and attempt to create a solution that solves adoption challenges inherent in the transition from USD LIBOR.
 
The major players at this point in credit-sensitive rates include:
 
AMERIBOR®: Published by the American Financial Exchange (AFX), an electronic exchange for more than 1,000 U.S. financial organizations, this index reflects member banks’ and financial institutions’ actual unsecured borrowing costs. It is calculated daily based on the average interest AFX users charge on another for unsecured overnight loans. With one-, three-, and 12-month structures, it is most supported by regional and community banks.
 
BSBY: Published by Bloomberg, the Bloomberg Short-Term Yield (BSBY) index reflects the average yields at which large global banks access USD senior unsecured marginal wholesale funding. It is calculated daily based on the wholesale primary market funding transactions (e.g., interbank deposits and CD, commercial paper).
 
The ICE Bank Yield Index (BYI): Published by IBA, the current LIBOR administrator, this index is designed to sit atop the implied term SOFR curve and serve as a measure of the average cost of funds for large international banks borrowing U.S. dollars for one-, three- and six-month tenors on an unsecured basis.
 
IHS Markit Credit Inclusive Term Rate/Spread (CRITR/CRITS): Constructed by IHS Markit, a conglomerate of data providers. This is a standalone rate designed to sit atop SOFR and uses certificates of deposit and commercial paper transactions, along with certain bond data, to reflect one-, three-, six-, and twelve-month bank borrowing costs on a senior unsecured basis.
 
Tradeweb/IBA constant maturity Treasury (CMT) rate: Published by Tradeweb, an electronic trading network, and IBA, this tracks the volume-weighted average price of on-the-run U.S. Treasury bills, notes, and bonds executed on Tradeweb’s dealer-to-client platform, and will include a variety of maturities ranging from one month to thirty years, effectively offering to provide a term risk-free rate alternative to SOFR.
 
Across-the-Curve Spread Index (AXI): designed by a group of academics led by Stanford Professor Darrell Duffie, the AXI spread adjustment would measure the recent average cost of wholesale unsecured debt funding for publicly listed U.S. bank holding companies and their commercial banking subsidiaries. It would take the weighted average (by transaction and issuance volume) of credit spreads for unsecured debt instruments with maturities ranging from overnight to five years.
 
It is too early to know if confidence in data underlying credit-sensitive rates will prove out over time. Initial reaction to BSBY, in particular, appears to be a recognition of its robustness with concerns over the same representativeness that plagued LIBOR. There is also the question of what rate is better for borrowers and investors: borrowers may prefer SOFR, which does not contain a credit component and therefore is generally lower and does not spike during periods of economic stress; but lenders may not be willing to extend credit in SOFR during these times of stress.
 
With the Loan Syndications and Trading Association (LSTA) expanding its recommended fallback language to include a “credit-sensitive rate” rider, and the Fed, FDIC, and OCC emphasizing they are not endorsing one rate over another, the waters have gotten muddier as far as what the benchmark landscaping will look like after LIBOR is officially retired. Banks have been empowered, for now, to make the choice that best meets theirs and their clients’ needs. But no matter which rate, or combination of rates, you choose to replace LIBOR, you should already be far into the ARRC’s Paced Transition Plan, and financial industry tech providers should be ready to provide support for the transition.
 
For more information on how to Stay on Track for LIBOR Transition, information on how AFS is working with the ARRC Business Loan Working Group (BLWG), how AFS systems are already supporting SOFR and other rates, or how we can help your institution, please contact Dean Snyder (dsnyder@afsvision.com).
 

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