FRB – Transitioning Away From LIBOR: Understanding SOFR’s Strengths and Considering the Path Forward

September 18, 2020 – FRB (NY) Senior VP Nathaniel Wuerffel spoke on the transition process away from LIBOR, on an understanding of SOFR strengths, and considering the path forward. The transition away from LIBOR is arguably one of the most significant and complex challenges that financial markets will ever confront at the end of 2021.

AARC Function

LIBOR panel bank submissions egregiously manipulated, giving rise to the Alternative Reference Rate Committee (AARC), comprised of a diverse group of private market participants. AARC convened by the FRB was charged with creating plans to transition away from USD LIBOR. AARC criteria guided its selection process to make sure it chose a “robust” benchmark.

SOFR – LIBOR Replacement

SOFR was chosen by AARC as the foundation for the transition away from USD LIBOR. The secured overnight financing rate (SOFR) was chosen because it is a broad measure of the cost of borrowing cash overnight in the US Treasury repo market. It is fully transaction-based and produced by FRB (NY) pursuant to IOSCO principles.

Commercial Loan Transition

LIBOR transition is complex and some banks have highlighted their concerns around using SOFR in Commercial Loans (CLs) in absence of a credit-sensitive spread. The business loan market is the largest of cash markets transitioning at around $3.4 trillion.

One challenge is the mismatch between banks’ unhedged cost of funds and SOFR-based CLs in an economic downturn, Credit-Sensitive Supplement (CSS) may be a natural hedge. Banks expressed views that a supplement to SOFR should be credit-sensitive, dynamic, based on unsecured funding, and reflective of marginal bank funding costs.

Some concerned about how potential credit-sensitive spread would intersect with features that banks may use to manage risk, such as commitment fees, and percentage rate floors. Many borrowers viewed the ability to hedge their loans in derivative markets as key consideration and wondered if a credit-sensitive supplement could impair hedges.

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