The terms LIBOR and SOFR may not be very familiar to you. But in a few months, both will be highly consequential.
LIBOR, or the London Interbank Offered Rate, and SOFR, the Secured Overnight Financing Rate, are pricing mechanisms of global financial products and are used as the benchmark by all banks and lenders with commercial loans. In 2022, the U.S. Federal Reserve formally adopted a rule implementing the Adjustable Interest Rate (LIBOR) Act, identifying benchmark rates based on SOFR instead of LIBOR. As such, by June 2023, SOFR will replace LIBOR for good.
The United Kingdom’s Financial Conduct Authority regulates LIBOR and has been the dominant benchmark rate in financial contracts for a long time. But it was widely considered too vulnerable.
A global scandal emerged in 2012 when several large financial institutions colluded to manipulate LIBOR rates by making trades appear more profitable than they were, or adjusting their values to turn a profit dishonestly. Exposures like this meant LIBOR was also subject to credit risks that SOFR is not, because SOFR is calculated by compiling a spread of transactions rather than bank submissions.
U.S. dollar LIBOR panels will wind down in 2023. In December 2022, one-week and two-month LIBOR tenors ceased and LIBOR stopped appearing in new contracts. Meanwhile, SOFR has traded roughly $1 trillion in daily volumes, representing a transparent rate derived from the United States Treasury’s repo market. Put another way, SOFR indicates the cost of borrowing cash that has been collateralized by Treasury securities.
A plan to carefully transition will smooth the switch between LIBOR and SOFR this year. Thus, your business needs to prepare accordingly for the financial impact of this change.
SOFR transactions are calculated through repo agreements, which involve one party to the deal putting up cash and the other putting up collateral. Make it part of your business’ routine, or the routine of your financial department, to check the New York Federal Reserve’s SOFR publication every morning.
SOFR transactions are secured, unlike LIBOR. However, they only involve U.S. dollars, whereas LIBOR included other currencies like the Euro, the Japanese yen, Swiss francs, and the British pound sterling. The term structure is also backward looking. Depending on your company’s trades and other financial arrangements, these details may or may not be concerning.
Some of your loan documents may still have LIBOR provisions or language within them, and while redacting and/or changing is typically a straightforward process, overlooking this step could cause you legal headaches regarding contract enforcement.
Be sure to set aside time to comb through all loan agreements and arrangements to look for fallback language, derivatives, interest payment provisions, and more. If the files are digitized, this is usually as simple as using the “find in document” feature.
Often, your promissory note or loan agreement provides for the substitution by the lender of the benchmark used to determine the interest rate. Your applicable interest rate may be based on LIBOR plus a margin, and when substituting the benchmark (LIBOR to SOFR), then the lender can adjust the margin to realize a substantively equivalent rate.
It is important to assess whether your internal financial systems are prepared for the LIBOR to SOFR switch and whether they can easily adjust to these new, alternative interest rate benchmarks. To ensure compliance and to save time, it also helps to know whether your business is prepared with spread adjustments for your contracts.
It’s typical for companies to outsource processes like accounting, taxes, human resources, information technology, and other operations. But this also means that these third-party partners will be affected by the switch to SOFR, and you need to know how well they understand and are responding to the change before June. Arrange a dedicated conversation at the earliest opportunity and have a plan in place if it appears that their preparedness levels are not as high as your own. With the right steps, everyone involved can harness the opportunities posed by this new mechanism.