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US benchmark reform panel endorses forward-looking rate to replace Libor

Libor transition updates

The group overseeing America’s transition away from Libor has endorsed a forward-looking interest rate, marking a crucial step in the race to replace the scandal-tarnished benchmark underpinning hundreds of trillions of dollars in financial contracts.

The Alternative Reference Rates Committee (ARRC), created in 2014 by the Federal Reserve to be the industry body to lead the Libor transition, has given its backing to a new term rate created by CME Group, which is based on the US’s preferred Libor replacement, known as Sofr.

The panel’s endorsement of a new rate less than six months before a critical switchover deadline underscores the growing pressure regulators and banks alike face to move away from the Libor lending benchmark.

The benchmark reform comes after Libor — which was set based on submissions from major financial institutions as opposed to market activity — was at the centre of a rate-rigging scandal a decade ago in which major banks were fined billions of dollars and traders faced criminal trials.

Regulators have determined that banks and companies should have largely moved off Libor by the end of the year, and have made preparations to switch their loans and derivatives, with a notional value of hundreds of trillions of dollars, into replacement rates. While existing dollar-denominated deals have been given an extension to help them shift, all new contracts will have to use an alternative reference rate from next year.

But shifting market participants off US dollar Libor, the biggest and most important Libor rate, has been slower than for other currencies.

The backing of term Sofr is pivotal, especially for the loan market. Sofr is an overnight rate, which allows interest to be calculated based on actual transactions at a point in time. But many companies have long preferred forward-looking term rates such as Libor because they give an indication of where the market expects rates to be in the future.

This is vital for corporate loans, where companies need to be able to plan for upcoming interest payments on their debt, rather than being told what they owe just a few days in advance of having to pay up. The new Sofr term rate is an attempt to draw the two different types of rates together.

Tom Wipf, chair of ARRC and vice-chair of institutional securities at Morgan Stanley, said the recommendation of term rates is an achievement for financial stability, marking the last objective of the group’s transition plan before the end of year deadline.

“Market participants now have all the tools they need as we enter the transition’s home stretch,” he said. “With just five months until no new [contracts are pegged to] Libor, significant work remains and I urge everyone with Libor exposures to immediately take action and base their new contracts on forms of Sofr.”

The sticking point that had held back the ARRC from endorsing term Sofr sooner had been that the volume of trading activity in derivatives markets tied to the forward-looking rate had not reached a level to give the group comfort that the rate was reliable.

This week, the market convention for US dollar-denominated interest rate swaps switched from Libor to Sofr for trades between dealers. In turn, the ARRC’s confidence in the trading activity underpinning Sofr has galvanised to a level where they feel comfortable endorsing term Sofr.

The hope is that the endorsement will spur companies into action and stop market participants from dragging their heels because it was not clear which alternative interest rate would become the new convention in some markets.

The group said it was only recommending the use of term Sofr for business loans and not more broadly for derivatives and other markets. The group still prefers the use of overnight Sofr rates that are based on real transactions where possible, but acknowledges the operational need for term Sofr in certain circumstances, such as for the loan market.

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