Background on LIBOR and SOFR.

Author:Brock, Emily Swenson
Position:Federal Focus

The London Interbank Offered Rate (LIBOR) is a global benchmark interest rate that is calculated daily. With $200 trillion in U.S. dollar exposures linked to it, LIBOR is the most widely used benchmark and has been called "the world's most important number." Financial products based on LIBOR include loans, corporate bonds, interest rate swaps, mortgages, student loans, and deposits. They also include municipal bonds and loans.

While ubiquitous, LIBOR became less suitable as a benchmark because it is meant to represent the cost of short-term unsecured borrowing by banks, and banks have substantially reduced their use of this type of borrowing. The LIBOR panel banks typically must submit rates based on their judgment rather than actual transactions, and many are understandably reluctant to continue doing so. Regulators and market participants are concerned that this "most important number" is no longer robust. The transition away from LIBOR became urgent in July 2017 when Andrew Bailey, head of the United Kingdom Financial Conduct Authority (FCA) and regulator of LIBOR, announced that they would not require panel banks to submit quotes underlying LIBOR after 2021. In light of these statements, the future existence of LIBOR is uncertain.

In 2014, the Federal Reserve formed the Alternative Reference Rates Committee (ARRC), a group that includes private-sector market participants to select a rate to replace USD LIBOR and guide the transition. After much analysis of the potential alternatives, the ARRC announced in June 2017 that it had selected a new rate, the Secured Overnight Financing Rate (SOFR), as the recommended replacement for USD LIBOR. The Federal Reserve began publishing SOFR in April 2018. The ARRC selected SOFR because:

* SOFR is fully based on actual transactions, and so does not rely on judgment.

* SOFR references multiple segments of the U.S. Treasury repurchase agreement market, the largest rates market in the world.

* SOFR's underlying market is resilient and robust.

* SOFR is a true "risk-free" rate suitable as a reflection of interest rates overall.

* SOFR is produced by the public sector using a transparent methodology.

* SOFR correlates well with other overnight money market rates and with the cost of borrowing for non-financial corporations.

To guide the transition, the ARRC was reconstituted in April 2018 with broad representation from official government entities, banks, asset managers, insurers, consumer groups, and...

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