April 3, 2018 / 5:02 AM / 8 months ago

EXPLAINER-What is SOFR? The new U.S. Libor alternative

April 3 (Reuters) - The New York Federal Reserve on Tuesday will begin to publish the Secured Overnight Financing Rate (SOFR), a rate that regulators hope will eventually be adopted to back U.S. dollar-based derivatives and loans. The aim is that the new rate will eventually reduce markets’ dependence on Libor.

Following are some facts about the rate.

What is SOFR?

SOFR is based on transactions in the Treasury repurchase market, where banks and investors borrow or loan Treasuries overnight. A group of large banks, the Alternative Reference Rate Committee (ARRC), selected the rate as an alternative to the London interbank offered rate (Libor) in derivatives. It cited the depth and robustness of the market where around $800 billion is traded daily.

Why do we need a new rate?

Regulators including Federal Reserve Chairman Jerome Powell are seeking to reduce markets’ reliance on Libor due to a decline in loans backing the rate. If the rate stops being published “that has all the potential of being a pretty significant financial stability problem,” Powell said in February.

The ARRC, which selected SOFR as an alternative rate, said in March that Libor underpins $200 trillion in derivatives and loans, more than previously thought, underscoring the necessity of promoting a robust alternative. Derivatives account for 95 percent of the exposures.

Why was there a decline in usage of Libor?

Reforms to banking and money market fund regulations resulted in fewer interbank short-term loans and reduced demand for the bank debt. Also, Libor’s reputation was damaged by charges that banks manipulated the rate before and during the 2007-2009 financial crisis, often to book larger profits on derivatives based on the rate. Libor rates are sometimes estimated rather than based on actual transactions.

Will it replace Libor?

SOFR is intended to work alongside Libor. Over time, regulators hope that more derivatives and loans will be backed by the rate, which will decrease the importance of Libor. The New York Fed’s publication of the rate is the first in a series of steps to enable a transition. The CME Group will begin trading futures based on the rate on May 7. Major dealers and clearinghouses that guarantee interest rate swap trades are also working to enable swaps based on the new rate. The head of Britain’s financial markets regulator said last year that a Libor substitute must be in place for banks to use by the end of 2021, and that Libor must be replaced because there are not enough transactions underpinning the rates.

Is this the first global effort to find an alternative?

No. Regulators have pushed internationally to find alternatives to Libor and its equivalents. A British committee last year selected SONIA, an unsecured overnight lending rate, as an alternative to sterling-based Libor and Japan selected TONAR as an alternative to yen Libor, also an unsecured rate. A group in Switzerland selected SARON, a collateralized rate based on the Swiss repo market.

The European Central Bank is developing a daily euro unsecured overnight index rate.

Editing by Chizu Nomiyama

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