Differences Between LIBOR and SOFR: A Financial Perspective

The transition from the London Interbank Offered Rate (LIBOR) to the Secured Overnight Financing Rate (SOFR) marks a significant shift in the financial landscape, particularly in the realm of benchmark interest rates. Here, we will delve into the key differences between LIBOR and SOFR, their implications, and the reasons behind this transition.

Definition and Calculation

LIBOR

LIBOR was a widely used benchmark interest rate that reflected the average interest rate at which major global banks borrowed from each other. It was calculated based on the submissions of a panel of banks, estimating the rates at which they could borrow from other banks for various maturities (e.g., 1-month, 3-month, 6-month, and 12-month). This forward-looking rate included a credit risk premium, as it was based on unsecured interbank lending.

SOFR

SOFR, on the other hand, is a transaction-based rate that reflects the cost of borrowing cash overnight, collateralized by U.S. Treasury securities in the repurchase agreement (repo) market. It is calculated based on actual transactions in the Treasury repo market, which averages around $1 trillion in daily volumes. This makes SOFR a more reliable and less susceptible to market manipulation and volatility compared to LIBOR.

Forward-Looking vs. Backward-Looking

LIBOR

LIBOR was a forward-looking rate, meaning it was set at the beginning of the interest period and reflected the expected borrowing costs over that period. This allowed borrowers and lenders to know the interest rate and payment amount at the start of the period.

SOFR

SOFR is a backward-looking rate, calculated in arrears. This means that the SOFR rate for a given period is determined at the end of that period, and the interest payment is calculated based on the average SOFR rate over the period. This can introduce uncertainty for borrowers and lenders, as they do not know the exact interest payment until the end of the period.

Risk and Collateral

LIBOR

LIBOR was an unsecured rate, meaning it included a credit risk premium since it was based on interbank lending without collateral. This made LIBOR more reflective of the creditworthiness of the banks involved.

SOFR

SOFR is a secured rate, backed by U.S. Treasury securities. This eliminates the credit risk premium, making SOFR a risk-free rate. To account for the credit risk, a spread is often added to SOFR when used in financial contracts.

Market Volume and Reliability

LIBOR

LIBOR was based on a relatively small number of transactions and relied heavily on the judgments of a panel of banks. This made it more vulnerable to manipulation and less reflective of actual market conditions. For instance, the most commonly traded LIBOR rate, the three-month USD rate, was supported by less than $1 billion in transactions.

SOFR

SOFR, in contrast, is based on a massive volume of transactions in the Treasury repo market, averaging around $1 trillion daily. This large transaction volume makes SOFR a more reliable and robust benchmark rate, less susceptible to manipulation and more reflective of current market conditions.

Transition and Implications

The transition from LIBOR to SOFR was driven by concerns over the validity and transparency of LIBOR. The Alternative Reference Rates Committee (ARRC), established by the Federal Reserve, recommended SOFR as the replacement for USD LIBOR. This transition was completed by June 2023, with SOFR becoming the standard benchmark rate for dollar-denominated derivatives and loans.

Impact on Financial Instruments

The transition affects various financial instruments, including derivatives, commercial loans, adjustable-rate mortgages, and private student loans. For example, adjustable-rate mortgages based on SOFR will have interest rates determined by the SOFR rate at the end of the fixed interest period, unlike LIBOR-based loans where the rate was fixed at the beginning of the period.

Challenges and Solutions

One of the challenges in transitioning to SOFR is the need for a forward-looking term SOFR to match the familiarity of LIBOR. While the compounded in arrears method is favored by ISDA, some market participants prefer a term SOFR that sets the rate at the beginning of the period, similar to LIBOR. To mitigate volatility concerns, the compounded average of SOFR over a month or quarter can smooth out daily fluctuations.

Conclusion

The shift from LIBOR to SOFR represents a significant evolution in benchmark interest rates, driven by the need for a more reliable, transparent, and less manipulable rate. SOFR's basis on actual transactions in the Treasury repo market and its secured nature make it a preferable alternative to LIBOR.