LIBOR is being phased out and may not exist by the end of 2021. Now what?
LIBOR, explained
What is LIBOR?
The London Interbank Offered Rate (“LIBOR”) is an interest-rate average calculated by the Intercontinental Exchange (NYSE: ICE) from estimates submitted by the leading banks in London. Contrary to the US federal funds rate, which is set by the US Federal Reserve Board, LIBOR is a market driven rate determined by supply and demand, and reflects the rate at which major global banks lend to one another in the international interbank market for short-term loans. LIBOR is calculated in five currencies, and the US Dollar LIBOR alone is referenced in approximately $200 trillion of outstanding financial products, including most commercial floating rate loans.
LIBOR is Rigged! Scandal places LIBOR in Jeopardy
Since its creation in 1986, LIBOR has been the default standard for commercial debt products because of its relative stability and predictability; however, in 2008 the Wall Street Journal published an article exposing potential rate manipulation of LIBOR, which placed LIBOR under increased scrutiny. In 2012, the UK Serious Fraud Office announced it was opening a criminal investigation into the manipulation of LIBOR. In 2017, the UK Financial Conduct Authority announced that it was effectively terminating LIBOR, and urged all banks to stop using the benchmark by the end of 2021, prompting financial institutions to begin to consider alternatives, with the Secured Overnight Financing Rate (“SOFR”) emerging as the leading contender as of the date of this article. In 2019, the UK Serious Fraud Office closed its criminal investigation.
A replacement emerges
In early 2018, fresh off the news that LIBOR would soon be phased out, the New York Federal Reserve began publishing SOFR with the hopes that it would eventually be adopted in the United States and replace LIBOR with respect to US Dollar debt products.
SOFR, explained
What is SOFR?
According to the Alternative Reference Rates Committee (“ARRC”), a group of private-market participants convened to help ensure a successful transition from LIBOR to a more robust reference rate, SOFR is “robust, is not at risk of cessation, and meets international standards.” SOFR is derived from the U.S Treasury repo market with about $1 trillion of transactions a day. The New York Fed publishes SOFR each business day at approximately 8:00 a.m Eastern Time. The ARRC has implemented a “Paced Transition Plan”, with a goal of widespread adoption of SOFR by the end of 2021.
Differences from LIBOR
SOFR differs from LIBOR in a few keys ways, which result in increased reliability for SOFR:
| SOFR | LIBOR |
| Overnight (backward looking) | Forward looking |
| Published by the NY Fed, a public entity | Published by the ICE Benchmark Administration, a private entity |
| Based on a transparent review of transaction data | Based on LIBOR bank estimates & expert judgement |
Some argue that SOFR will result in increased volatility due to day-to-day fluctuations in supply and demand. However, according to the ARRC, the published SOFR rates used in finance products, such as 1-month SOFR, 3-month SOFR, 6-month SOFR (each of which are averages of the overnights rates), smooth out almost all of this volatility. In fact, a three-month average of SOFR is less volatile than 3-month LIBOR.
Implementing LIBOR in Real Estate Loan Documents
Most floating rate commercial real estate loans use LIBOR, and include provisions that state that the Prime Rate will be used in the absence of LIBOR. Although the Prime Rate is oftentimes significantly higher than LIBOR (and therefore unattractive to borrower), this language has not been highly negotiated, since most floating rate loans carry terms of 3-5 years. However, with the elimination of LIBOR now just over the horizon, borrowers have placed increased emphasis on the inclusion of language that adequately addresses a LIBOR phaseout. In the absence of a clear leader, this language was often broad and included language to the effect that the borrower and lender would select a rate that was “widely used in similar commercial real estate transactions.” Now that a clear leader has emerged, borrowers and lenders have begun to specifically insert SOFR replacement language.
In late 2019, the ARRC published its “final recommended language” for a series of loan products, including adjustable rate mortgages, securitizations, syndicated loans, and floating rate loans. The language is suggested for insertion into loan documents in an effort to provide a standard for the future phaseout of LIBOR during the pendency of LIBOR loans. The language provides for SOFR as the replacement, and while there is some wiggle room for negotiation, most lenders have pushed to insert the language as-is, without changes. We expect to see such language widely deployed in all LIBOR loan documents until LIBOR is fully shutdown.
Conclusion
The death of LIBOR will surely be difficult, but there has been sufficient time for the markets to digest it. SOFR is the clear leader as a replacement rate in the United States, and should see increased deployment in the months to come.
