LIBOR and SOFR Transition

LIBOR is based on quotes submitted by banks. Its reputation as the market standard was tainted due to various scandals that emerged post 2008 financial crisis thus signaling an inefficiency of the decades-old benchmark. Globally, officials wanted to gravitate towards a rate that was not dependent upon submissions but rather based upon interest rate transactions which are transparent and provide insight into market liquidity.

After considering a number of alternatives, the Alternative Reference Rates Committee (ARRC) selected a "a broad Treasuries repo financing…as the rate that, in its consensus view, represents best practice for use in certain new U.S. dollar derivatives and other financial contracts." This rate was subsequently named the "Secured Overnight Financing Rate" or "SOFR" for short.

SOFR is the anticipated replacement rate for LIBOR across many financial products, including commercial and corporate loans, publicly traded bonds, and derivative products.

Due to the extensive use of USD LIBOR, many will be impacted, including: retail customers, corporations, issuers, investors, asset managers, financial products service providers and large financial institutions. This is a market-wide transition, affecting all major financial institutions.

SOFR can be used as a reference across a broad range of financial products, including—but not limited to—derivatives (listed, cleared and bilateral-OTC) and many variable-rate cash products that have used LIBOR as their reference rate in the past.

Published daily by the Federal Reserve Bank of New York, "SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities."

Additional information about the rate calculation and methodology can be found on the Federal Reserve Bank of New York's website.

SOFR differs in its construction from LIBOR, given that it is a secured-overnight rate, while LIBOR is a term, unsecured rate. SOFR is calculated based on a larger amount of underlying transactions, averaging over $1 trillion in daily transactions in 2020. In contrast, LIBOR reflects the funding costs of sixteen panelist banks.

Importantly, SOFR is a domestic rate and calculated by the Federal Reserve Bank of New York. Additionally, SOFR complies with international benchmark practices. LIBOR is a rate calculated and regulated in the United Kingdom.

Given SOFR is a daily rate, interest is accrued and then paid in arrears. As such, interest due is known at the end of an accrual period. LIBOR is a forward-looking term rate, so payments are known at the beginning of an accrual period. There is an on-going request for proposal for the publication of forward-looking SOFR term rates. However, at the time of this FAQs publication, no such term rates are yet available.

In the summer of 2017, the United Kingdom Financial Conduct Authority (FCA) announced it would no longer compel member banks to submit LIBOR rates after end-2021. It would be determined by each member bank whether to continue submitting LIBOR rates thereafter.

On November 30, 2020, IBA announced its intention to consult on the extension of certain USD LIBOR settings for use in legacy contracts through end-June 2023. A same-day joint statement by several U.S. domestic regulatory agencies noted an extension of certain LIBOR settings would allow most legacy USD LIBOR contracts to mature before LIBOR experiences disruptions. The statement also noted that usage of LIBOR in new contracts after end-2021 could create safety and soundness risks and encouraged banks to cease entering into new USD LIBOR contracts as soon as practicable.

Certain USD LIBOR settings may continue to exist past 2021, and even out to end-June 2023, but LIBOR could be discontinued as a benchmark rate.

The transition is currently on-going but affects types of transactions differently.

There have been many SOFR-linked issuances of debt offerings in the floating rate note and commercial paper markets. There have also been numerous SOFR-linked derivative transactions reported to Swap Data Repositories (SDR).

In the bilateral and syndicated loan markets, the transition timeline will depend on a few factors, including the maturity of the transaction and what, if any, rate-transition language has been included in the documentation.

For existing LIBOR-based lending transactions, that mature within a June-2023 timeframe, there is the expectation that they could continue until maturity, with little or no changes needed.

For existing LIBOR-based lending transactions that mature after June-2023, a review of documentation is needed to determine what, if any, changes will be needed. For instance, if the lending documents already have robust rate fallback language that outlines what rate will replace a permanent cessation of LIBOR, little or no changes may be needed. However, for existing LIBOR-based transactions that mature outside of June-2023 and lack or have inadequate rate transition language, changes would be necessary.

For upcoming new transactions, or for existing transactions with maturity extensions, SOFR-based pricing, rate calculations and methodology are expected to be phased in over the course of the second half of 2021.

For ISDA-documented derivative transactions, such as swaps, updated definitions and a protocol have already been published. These can be found here. Under these documents, LIBOR is expected to be re-defined, under specified trigger events, as a compounded risk-free rate (i.e. SOFR) plus a credit spread component.

Spread adjustments are needed to compensate for the difference in rate construction between the benchmarks, including the shift from an unsecured index to a secured index in existing and future contracts.

Ensuring adequate transition language in transactions should make transactions continue without interruption or confusion.

Most LIBOR-linked derivative transaction documents do not currently contemplate or specify what will happen if LIBOR is permanently discontinued. To remedy this, we will be requesting clients with existing transactions to enter into amendments to ensure both parties have a clear agreement on how a permanent discontinuation of LIBOR will impact their derivative transaction(s).

For ISDA-based transactions, that would entail signing the currently available ISDA protocol (available here online) and/or entering into a bilateral agreement with Fifth Third.

For lending transactions, language found in loan documentation will dictate what happens when LIBOR ceases to permanently exist, so that transactions can continue to their maturity.

Fifth Third will be reaching out to its clients as the transition timeline progresses.

Fifth Third expects to begin writing new SOFR-based transactions in the second half of 2021. This timeline may change as industry SOFR conventions evolve and standardize in lending transactions.