LIBOR vs. SOFR

Attribute	LIBOR	SOFR
Full Form	London Interbank Offered Rate	Secured Overnight Financing Rate
Calculation	Based on interbank lending rates	Based on overnight Treasury repo transactions
Underlying Market	Unsecured interbank lending market	Secured overnight lending market
Regulation	Administered by ICE Benchmark Administration	Administered by Federal Reserve Bank of New York

Introduction

LIBOR (London Interbank Offered Rate) and SOFR (Secured Overnight Financing Rate) are two key interest rate benchmarks used in financial markets. Both rates play a crucial role in determining the cost of borrowing for financial institutions, corporations, and consumers. However, there are significant differences between the two benchmarks in terms of calculation methodology, underlying transactions, and regulatory oversight.

Calculation Methodology

LIBOR is calculated based on submissions from a panel of banks, which report the interest rates at which they could borrow funds from other banks in the London interbank market. The rates are then averaged to determine the daily LIBOR rate for various currencies and tenors. In contrast, SOFR is based on actual transactions in the overnight repurchase agreement (repo) market, where financial institutions borrow and lend cash overnight using U.S. Treasury securities as collateral.

Underlying Transactions

One of the key differences between LIBOR and SOFR lies in the underlying transactions that each benchmark is based on. LIBOR is derived from unsecured interbank lending transactions, where banks lend to each other without posting collateral. This lack of collateralization has raised concerns about the reliability and integrity of LIBOR, especially after the manipulation scandals that came to light in the aftermath of the financial crisis. On the other hand, SOFR is based on secured transactions in the repo market, where borrowing is collateralized by U.S. Treasury securities, making it a more transparent and robust benchmark.

Regulatory Oversight

Another important distinction between LIBOR and SOFR is the regulatory oversight and governance framework that governs each benchmark. LIBOR has historically been administered by the Intercontinental Exchange (ICE) Benchmark Administration, with oversight from the UK Financial Conduct Authority (FCA). However, in response to the manipulation scandals and the decline in interbank lending activity, regulators have announced plans to phase out LIBOR by the end of 2021. In contrast, SOFR is published by the Federal Reserve Bank of New York and is endorsed by the Alternative Reference Rates Committee (ARRC), a group of market participants convened by the Federal Reserve to facilitate the transition away from LIBOR.

Volatility and Stability

One of the criticisms of LIBOR is its susceptibility to manipulation and volatility, especially during times of financial stress. The reliance on bank submissions and the lack of underlying transactions have made LIBOR vulnerable to manipulation by individual banks seeking to profit from their positions. In contrast, SOFR is based on a robust and transparent methodology that is anchored in actual transactions in the repo market, making it less susceptible to manipulation and providing greater stability during periods of market turbulence.

Transition and Implementation

The transition from LIBOR to SOFR has been a major focus for financial institutions, regulators, and market participants in recent years. The ARRC has developed a comprehensive transition plan to facilitate the adoption of SOFR as the new benchmark rate for financial contracts, including derivatives, loans, and securities. Market participants are encouraged to transition away from LIBOR and adopt SOFR-based products to mitigate the risks associated with the discontinuation of LIBOR after 2021.

Conclusion

In conclusion, LIBOR and SOFR are two key interest rate benchmarks with distinct characteristics and implications for the financial markets. While LIBOR has been a widely used benchmark for decades, its reliance on bank submissions and susceptibility to manipulation have raised concerns about its reliability and integrity. In contrast, SOFR is based on actual transactions in the repo market, making it a more transparent and robust benchmark that is less prone to manipulation. The transition from LIBOR to SOFR is underway, and market participants are encouraged to prepare for the discontinuation of LIBOR by adopting SOFR-based products and contracts.