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6 November 2020

Understanding the Secured Overnight Financing Rate

As with the replacement of GBP LIBOR with SONIA, USD LIBOR is scheduled to be removed from use by the end of 2021. The replacement Secured Overnight Financing Rate (SOFR), an overnight, near-risk-free rate, is currently being rolled, but its adoption has many implications for the market.

When it became apparent that a replacement was needed for USD LIBOR, the Alternative Reference Rates Committee (ARRC) was convened by the Federal Reserve Board and the New York Fed to identify a robust alternative and set the stage for a transition to the new rate. The ARRC’s members are a diverse group of private-sector entities with significant presence in markets affected by USD LIBOR, including banks and the financial sector.

The objective of the ARRC was to ensure that the successor rate would not be susceptible to the same shortcomings as USD LIBOR. Instead, it would be anchored in observable transactions in deep and active markets and produced in compliance with international best practice. 

The Secured Overnight Financing Rate (SOFR) was first adopted in June 2017, after a lengthy consultation and evaluation process. It is provided daily by the Federal Reserve Bank in New York. SOFR is described as ‘a broad measure of the cost of borrowing cash in the overnight repurchase market collateralised by US Treasury Securities’.

 The key features of SOFR

  • Unlike USD LIBOR, SOFR is backed by significant transaction volumes in an active market with a diverse set of lenders and borrowers.
  • Like other designated LIBOR successor rates, such as SONIA, SOFR is also an overnight, risk-free or near-risk-free rate.
  • SOFR, similar to other alternative reference rates, are backward-looking instead of forward-looking like LIBOR.

The world's transition to SOFR 

Because SOFR is an overnight, near-risk-free rate, users will face similar challenges to those that have arisen in other term rates to overnight rates transitions. Replacing USD LIBOR with SOFR will not be a simple like-for-like transition. 

In preparing for USD LIBOR’s replacement at the end of 2021, and considering the key differences in rates, the ARRC has done a significant amount of work, producing numerous tools to support the market adoption of SOFR as the designated successor to LIBOR. 

Although the transition is by no means without difficulty, regulators have been increasingly emphasising the need to commence the transition away from LIBOR before 2022, with the key message being that market participants should not wait for all relevant factors (such as the availability of forward-looking term rates) to be finalised before commencing their transition. 

In fact, in both the US and the UK transitions, there are explicit expectations that market participants can commence offering new non-LIBOR-linked exposures before (and in some instances long before) LIBOR’s cessation. 

How to transition to SOFR 

We recommend you consult the various publications available on the ARRC website, which provide recommended best practices to embed in your transition planning. These include the following:

  • Having clear internal programmes in place
  • Identifying LIBOR exposures, keeping abreast of ARRC recommendations and engaging in ongoing dialogue with key stakeholders 
  • Taking active steps to transition

The ARRC had provided guidance for the use of SOFR across many products (loans, swaps etc.) and has recommended fallback legal language in the event that current USD LIBOR is no longer published. The SOFR Starter Kit published by the ARRC provides a helpful summary of the transition from USD LIBOR as well as links to the various market adoption tools mentioned above. Based on your own usage of LIBOR and exposure, you may wish to use whatever external legal, accounting and other advisers you consider to be necessary.