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11 December 2019

Transitioning from LIBOR to SOFR

By Katherine Pearce and Nick Nolan

Seldom is there a monumental shift in the world of accounting and operations that is related to loans and derivatives. US0003M is the market identifier for the US Dollar 3-Month LIBOR (London Interbank Offered Rate), and in less than 800 days it appears it will be no more, as the entire LIBOR Index will cease to exist by the end of 2021.1  Let’s examine what led to this change and what to expect moving forward.

There are a couple of key reasons LIBOR is going away:

  • LIBOR isn’t really reflective of any actual interbank funding. 2
  • The rate can easily be manipulated, since banks submit these numbers to the British Bankers Association. The main regulator in the UK, the Financial Conduct Authority (FCA), will no longer require banks to make submissions at the end of 2021. 3
  • There is very little trading volume associated with LIBOR despite it being the rate used for trillions of loans and derivative contracts. According to the ARRC (Alternative Reference Rate Committee), there is less than $500m in daily trading activity for the 3-month LIBOR. 3

The Federal Reserve summoned the ARRC in 2014 to identify an alternative to LIBOR that would be a “robust, IOSCO-compliant, transaction-based rate derived from a deep and liquid market.” 4 In 2017, the ARRC selected the Secured Overnight Financing Rate (SOFR) as the successor to LIBOR. SOFR is based on overnight transactions in the USD Treasury repurchase agreement or repo market, which is roughly $1 trillion per day. The rate is produced daily at 8:00 AM EST by the New York Federal Reserve. 4  At the LSTA’s annual conference at the end of October in New York, much of the conversation was around the transition from LIBOR to SOFR and operationalizing four potential variants of SOFR5:

  • Forward Looking Term SOFR: Closest to LIBOR, this would have the least impact on accounting and loan systems. However, this rate has not yet been developed and would need to be created through Futures trading. 5
  • SOFR Compounded in Advance: A SOFR that uses the prior month’s rate as the interest rate for the accrual period. For instance, a credit contract’s accrual that begins on July 1 would use a compounded SOFR from June 1 through June 30. Many participants don’t like this due to the stale nature of the rate. 5
  • Daily Simple SOFR in Arrears: The simple interest method is the way many bonds and loans calculate accruals, which is calculated as Principal X daily rate of interest, and the resulting payment is the bearer’s cash flow. Many business systems now can consume and reset a reference index daily on a loan or bond and use that for an accrual. This method presents challenges around invoicing and servicing loans. 5
  • SOFR Compounded in Arrears: This variant uses a daily SOFR and compounds it over the interest period. This is the direction ISDA has chosen to go with derivative contracts, and that many believe will be the direction for the loan market as well. From a business systems perspective, it is very different than the way accruals are currently calculated for loans and other cash products. Interest is calculated as (Principal + Accumulated Interest) X daily rate of interest. 5

With LIBOR ending, the LSTA has laid out several key considerations that accounting systems will need to address moving forward. We feel confident that SS&C Advent’s Geneva will be able to support these proposed changes. For example, we recently made a series of successful enhancements, like compounding within our fixed income investment functionality, which we will be rolling into our Loan Investment feature next year. These enhancements include:

  • Daily
  • Daily Bus Day (to compound daily on business days only)
  • Euro Short-Term (for Euro short-term rate swaps, also called ESTR swaps, formerly EONIA swaps)
  • Weekly
  • Monthly
  • Quarterly
  • Semi Annually
  • Annually

In addition, some other LSTA considerations that Geneva will be well equipped to support are:

  • Spread Adjustment: This is a rate that will make assets that convert from LIBOR to SOFR contracts more comparable, currently supported in our Variable Rate Schedule.
  • Flat Compounding: This means the index gets compounded but the spread does not. This capability is targeted in Geneva 20.1
  • Day Count: Geneva offers a wide range of Day Count Conventions to calculate or determine how interest accrues over time.
  • LookBack: Current functionality exists to look back on the Benchmark Index.
  • Floors and Caps: Functionality currently exists to manage rate determination.
  • Lockout Days: The last “x” days of the coupon period. The VRS uses the same index value instead of looking up. Targeted in Geneva 20.1

Due to the fluidity of decisions around the LIBOR to SOFR transition, we are monitoring the situation closely with clients and other industry partners. We remain agile in our development approach to ensure we best support our clients through this change. Meanwhile, feel free to contact your Geneva representative with any questions or comments.

 

Citations:

[1] ICE Benchmark Administration Limited (IBA), 3-Month London Interbank Offered Rate (LIBOR), based on U.S. Dollar [USD3MTD156N], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/USD3MTD156N, November 19, 2019.

[2] Bailey, Andrew. “The future of LIBOR.” Speech at Bloomberg London, UK. July 27, 2017.

[3] Alternative Reference Rate Committee (ARRC). Transition from LIBOR. Access date December 2, 2019.

[4] Federal Reserve Bank of New York. A User’s Guide to SOFR: The Alternative Reference Rates Committee. April 2019.

[5] Coffey, Meredith. U.S. Libor Transition: Demystifying SOFR. Loan Syndications and Trading Association (LSTA). Access date December 2, 2019.