Life after Libor: SOFR takes center stage as the new loan benchmark

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      By Andrew Sveen, CFACo-Director of Floating-Rate Loans, Eaton Vance Management and Christopher RemingtonInstitutional Portfolio Manager, Eaton Vance Management

      Boston - As the reign of Libor draws to a close — most likely by the end of 2021 — its heir apparent is coming into sharper focus: the Secured Overnight Finance Rate (SOFR). U.S. dollar Libor, or the London Interbank Offered Rate, is the floating benchmark referenced by about $1 trillion of floating-rate loans, and about $200 trillion of financial contracts altogether, according to the Loan Syndications and Trading Association (LSTA) and the New York Federal Reserve Bank (NY Fed).

      This Q&A addresses questions and concerns about the impact of the transition with brief background on Libor and relevant points about SOFR. (Spoiler alert: we fully expect a smooth transition.)

      Why is Libor being phased out?

      The market Libor was originally designed to reflect — lending between banks — barely exists anymore, and most of the input for the rate reflects estimates, rather than actual transactions. That made it susceptible to manipulation and controversy.

      The transition to "life after Libor" took on new urgency in July 2017, when Andrew Bailey, the chief executive of the UK Financial Conduct Authority (FCA) announced that after 2021, the regulator would no longer compel banks to support Libor with their rate quotes.

      What is SOFR?

      SOFR is the combination of three overnight U.S. Treasury repurchase agreement (repo)1 rates. It is very liquid, with roughly $1 trillion of trading daily, according to LSTA. This means that it will likely be robust, durable and hard to manipulate — all alleged shortcomings of Libor.

      SOFR was developed by market participants through the Alternative Reference Rates Committee (ARRC) under the auspices of the U.S. Federal Reserve (Fed) and the NY Fed. ARRC officially designated SOFR as the successor to U.S. Libor in June 2017. The NY Fed administers SOFR and publishes the rate daily on its website at 8 a.m.

      Repo market volatility, including large spikes in the rate, has been in the news lately. How would that affect SOFR?

      The daily repo rate has always been volatile, but only rarely has it experienced spikes like the recent activity (see chart below). The exact methodology for computing SOFR as a loan benchmark is still under discussion, but the rate will almost certainly be based on an average — most likely one to six months.

      The chart shows the powerful smoothing effect of averaging. SOFR's daily volatility is evident, as is the atypical one-day spike in September, but the three-month average is smooth - the spike has negligible impact on it. The three-month U.S. Libor rate is included for reference. Based on the NY Fed data in the chart over the past five years, Libor and the three-month SOFR average have the same volatility based on standard deviation.2

      Moreover, the Fed has been committed to addressing the root cause of the spikes: reluctance by banks to lend in the repo market at times of market stress. The Fed's lending in the market helped bring down the repo rate down to more typical levels.

      3-Month SOFR and Libor have had the same volatility, despite September's repo rate spike. SOFRvLibor_680px

      Source: New York Federal Reserve Bank, as of October 22, 2019. Data provided is for informational use only. Past performance is not a reliable indicator of future results.

      Will the loan market be ready in time for the transition to SOFR?

      We believe there are solid reasons why the transition will happen without a ripple. To start, loans are relatively short-term contracts. Because of routine repayments, about a third of the $1 trillion market is refinanced each year, and each refinancing requires a new contract that specifies the benchmark. So in the natural course of the market, more than two-thirds all issuers will have the opportunity to adopt SOFR in new issuance by the 2021 Libor phase-out date.

      But the transition is already well underway, thanks to the flexibility of most loan contracts. Most have "fallback" language that specifies another reference rate — such as the prime — in the event Libor becomes unavailable. (This has been a longstanding feature of loan credit agreements.) The LSTA reports that updated fallback language has been routinely included in new and amended credit agreements, enhancing the ability of market participants to adopt SOFR at the appropriate time.

      For example, most loans typically have triggers specifying when and how a new benchmark is selected. New language suggested by ARRC includes an "early opt-in" trigger. In the event the cessation of Libor is preannounced, this language would permit the contract amendment process to begin up to 90 days before the Libor cessation date. The purpose is to facilitate the necessary technical, administrative and operational changes.

      LSTA is a key member of the ARRC, and co-chairs the Business Loans Working Group and the Business Loans Operations Subgroup, and has been an actively engaging market participants in transition planning — it is a top priority for the LSTA.

      Beyond the details, it's worth recalling that the loan market comprises sophisticated buyers and sellers who share the same incentive to have an uneventful transition to SOFR, just like it was in the 1990s when the benchmark was switched from the prime rate to Libor.

      Bottom line: We are confident that Libor's sunset will be comparably tranquil.