Why Is SOFR Replacing LIBOR (and Why Does It Matter)?
In June of 2023, LIBOR (The London Interbank Offered Rate) will be replaced. The previous deadline was set for December of 2021 but has since been extended.
LIBOR has thus far had a significant influence on how interest rates are set in the U.S. It has been used worldwide to be a benchmark for determining the interest rate at which banks can borrow from each other. LIBOR has been used for financial contracts, loans, securities and other bonds and derivatives.
Why the change?
LIBOR has been under scrutiny over the past several years. In 2012, many banks were under investigation for falsely reporting numbers and manipulating rates. These activities were found to have been going on for over a decade.
In 2017 the FCA (Financial Conduct Authority) ruled that LIBOR was no longer viable to base interest rates due to inactivity in the market and loans being declined.
The Federal Reserve has been looking for an alternative and has recently found one with SOFR.
What is SOFR?
SOFR (Secured Overnight Financing Rate) is based on transactions in the repurchase market where the cost of borrowing overnight is measured and reported daily by the Federal Reserve in New York. All transactions are secured and backed by the U.S Treasury.
What are the benefits of SOFR?
- SOFR is based on a much higher volume of trades that occur daily. This allows it to provide a much better standard since it is more sensitive to day-to-day market movements.
- SOFR is risk-free and secure, so credit risk premiums are not included in the rate.
- SOFR is more reliable than LIBOR because it is based on actual transactions and not just the claims of financial institutions. LIBOR looks forward to providing a benchmark while SOFR looks back.
What does this mean to you?
The advantage of an Adjustable-Rate Mortgage (ARM) is that it carries a lower interest rate during the fixed period of the loan. With SOFR in place, there is more reliability to an ARM after that period has expired, making SOFR the best choice for borrowers. Brokers can now give their borrowers this option and added peace of mind.
All new contracts should begin to use SOFR as a reference instead of LIBOR. For any existing LIBOR-based contracts, organizations should make the necessary changes to avoid potential risk exposure.