USD LIBOR transition to SOFR: Making it happen
Managing potential transition scenarios
LIBOR transition is December 31, 2021, but many market participants remain unclear about the level of risk that converting existing contracts might pose, and they’re unsure about engaging new business with recommended replacement rates. This is a particularly acute issue where the market is very large (over $200 trillion in notional value of derivative and cash contracts) and where product breadth touches all client segments, including individual borrowers.
The Secured Overnight Financing Rate (SOFR) was announced as the recommended USD LIBOR replacement in June 2017 and has since been adopted in select product areas (e.g., futures, floating rate notes), but the liquidity in the broader derivative and lending market is yet to fully materialize. Here we’ll explore the most likely transition scenario as well as potential strategies for using SOFR to price and risk manage both financial products and funding. We’ll also discuss its potential and the challenges faced in trying to introduce credit sensitive alternatives to LIBOR.
Key challenges
Many operational issues are slowing the transition to SOFR. To name a few:
- Lack of industry consensus building on conventions for using SOFR (e.g., how to average?) Different standards are emerging across product types.
- Contract identification and remediation Contract digitization remains in the early stages, leaving significant contract review work for most.
- Volatility in overnight SOFR This is clearly a PR issue but it’s economically not as material because market participants effectively use compounding or averaging.
- System changes and model development requirements across the industry The scale of the work is large and varying SOFR conventions by product type don’t help.
- Finalization of accounting, tax, and regulatory relief to support the transition US regulatory and accounting bodies reacted fast and finalization is expected in the coming months.
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