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The Race to Replace LIBOR: Understanding SOFR and BSBY

Published onFeb 02, 2022
The Race to Replace LIBOR: Understanding SOFR and BSBY

December 31, 2021—the date that had been looming over the financial world for the last few years—has finally come and gone. It was on this day that one-week and two-month U.S. dollar London Inter-Bank Offered Rates (LIBOR) ceased to be published.

Established in 1984, LIBOR was a daily calculated and globally accepted benchmark interest rate. However, in 2012 an investigation revealed international banks had been manipulating LIBOR for profit, dating back to 2003. Due to the erosion of public trust, LIBOR experienced a decline in its trust as a household benchmark interest rate. As a consequence, two alternative rates stepped into the spotlight: (1) Term Secured Overnight Financing Rate (SOFR) and (2) the Bloomberg Index Services Limited (BSBY).

On July 29, 2021, the Alternative Rates Reference Committee (ARRC) formally recommended the adoption of SOFR term rates and first identified it as a recommended alternative to LIBOR as early as March 2018. As the leading authority on the transition to an alternative reference for U.S. dollars both domestically and internationally, ARRC’s recommendation carried a lot of weight. ARRC was slow to recommend SOFR because up until May 2021, SOFR was only available as a daily rate, which meant it could not act as a viable replacement rate for U.S. dollar LIBOR. To replace LIBOR with a daily rate would require substantial changes in the way interest rates are calculated and reported. However, Term SOFR came to light as a viable replacement to LIBOR. It functions as an alternative to U.S. dollar LIBOR because it is determined “in advance” and thus requires less of a change for syndicated and bilateral loan facilities than other SOFR rates, such as daily SOFR. An application of the Spread Adjustment is, however, required to obtain an equivalent of an existing LIBOR margin. Other than that, Term SOFR works similarly to that of LIBOR and will serve as a capable replacement.

Another proposed replacement to LIBOR, which launched on January 20, 2021, is Bloomberg Short Term Bank Yield Index (BSBY). BSBY is reported at 8 a.m. EST every business day. It is also available in tenors of overnight, one-month, three-months, six-months, and 12-months. Where BSBY differs from SOFR is that there is no spread adjustment. To explain this, BSBY published a white paper detailing its credit spread and term structure. The benefit of BSBY is that it establishes a benchmark for transactions through incorporated traded rates across a variety of bank issuers. BSBY also tracks closely with the historical rates of U.S. dollar LIBOR at each tenor.

With LIBOR’s recent cessation on December 31, 2021, as a representative rate of market and economic trends and LIBOR’s last publication on June 30, 2023, the end is fast approaching. Many LIBOR benchmark settings are now being synthetically produced due to the cessation of some LIBOR publishing. Lenders must figure out the most advantageous replacement rate to plug into existing contracts and what to use in new ones. Loans need to be transitioning away from LIBOR now if they haven’t already. With the variety of replacement rates floating around it remains to be seen which will win the race to replace LIBOR.

The tipping point for determining whether SOFR or BSBY wins this race could be whether it is SOFR or BSBY that takes the prominent position held by LIBOR in the millions of existing loans. There is no definitive answer as to which alternative rate will most seamlessly replace LIBOR. The best approach is to understand how both Term SOFR and BSBY work, which will allow for preparedness when one pulls ahead in this race to replace LIBOR.

Teala Volkamer is a second-year law student at Wake Forest University School of Law. Teala graduated from the University of British Columbia in 2019 with a bachelor’s in sociology. Upon graduating from law school, Teala intends to practice transactional law.

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