In 2018, the Federal Reserve’s Alternative Reference Rate Committee (ARRC) selected the Secured Overnight Financing Rate to replace USD LIBOR, the main reference rate used in credit instruments in the U.S. With more than $200 trillion of financial instruments based in USD LIBOR, the transition to an alternative reference rate should be followed closely.
CoBank and the Farm Credit System have been working diligently with several bodies responsible for providing feedback on the functionality of the financial system with a new reference rate. This page features some educational materials and resources to learn more about LIBOR and potential changes coming to the industry.
What is LIBOR?
LIBOR (London Interbank Offered Rate) is an estimate of the cost of borrowing/lending for banks on an unsecured basis. The rate is determined each day based on rate submission from panel banks.
How important is LIBOR?
U.S. Dollar LIBOR is the dominant reference rate for financial instruments, particularly floating rate loans. The size of the contracts indexed to U.S. Dollar LIBOR is estimated to be more than $200 trillion. Many floating rate loans in the rural agriculture and rural infrastructure sectors currently use U.S. Dollar LIBOR as a reference rate.
What is changing with LIBOR?
U.S. and international banking regulators have been expressing concern about LIBOR over the past several years. The primary concern is that the lack of a deep and liquid market in unsecured intra-bank transactions has reduced the reliability of LIBOR as an index and the market needs to transition to an alternative reference rate for floating rate transactions.
Beginning in 2022, the United Kingdom’s Financial Conduit Authority (LIBOR’s primary regulator) will no longer compel banks to submit estimated rates and there is concern that publishing of LIBOR will not continue beyond 2022.
Has an alternative reference rate been proposed?
The Federal Reserve convened the Alternative Reference Rate Committee (ARRC), which has recommended the creation of an alternative called the Secured Overnight Financing Rate (SOFR) as a replacement benchmark rate. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities and is completely transaction based. The Federal Reserve Bank of New York began publishing SOFR trading data on April 3, 2018.
What's next in the LIBOR transition process?
Financial market industry workgroups, regulators and fixed income market participates will be working to develop the new SOFR markets and the process for transitioning to it. SOFR futures and swaps are now in existence and some cash instruments have also been issued.
The market has yet to determine the timing and the adjustments that will be made to the existing LIBOR transactions in order to minimize any transfer of value.
What is CoBank doing with regard to this issue?
As members of several industry-wide committees and regulatory advisory committees, CoBank and other Farm Credit institutions are actively monitoring and participating in discussions with industry groups and financial regulators about the transition of LIBOR as a benchmark for floating rate transactions. It is expected that LIBOR will continue to be in use through at least 2021, but given the potential significance of the change, CoBank is actively reviewing the latest developments now to help prepare ourselves and our customers. CoBank, on behalf of the four Farm Credit Banks, submitted multiple consultations to the Fed’s ARRC, ISDA and the Commodities Future Trading Commission for their consideration.
Wall Street Journal Prime (Prime) is a prominent benchmark rate that tracks with the federal funds rate and was once offered by CoBank as a variable price index. Is it possible to transition back to a Prime based Index rather than SOFR?
Although the Prime index still exists in the lending and debt market, the index has major problems. First, Prime is an unregulated rate which the Wall Street Journal (WSJ) defines as "the base rate on corporate loans posted by at least 70% of the 10 largest U.S. banks." Additionally, the WSJ is not legally bound to publish the rate and could discontinue providing the rate at any time. In 2013, the International Organization of Securities Commissions (IOSCO) published Principles for Financial Benchmarks ("the Principles"), a set of recommended practices for administrators of financial market benchmarks. The Principles have been endorsed by the Financial Stability Board as representing best practices. Prime does not meet the criteria to be considered an IOSCO compliant rate.
Second, there is a very limited market for FFCB Floating Rate Notes (FRNs) issuance indexed to Prime. There is estimated to be $15 billion of Prime FRNs outstanding and 99% is issued by the FFCB. Further, the FFCB Prime FRNs has a very limited distribution and is concentrated in money market funds. The top ten investors hold over 70% of Prime issuance and the top five hold over 50%. This creates liquidity issues, if any of these top investors pull out of the Prime market. Additionally, these money market investors will not purchase any issuance longer than two years, which will create liquidity constrains for CoBank as it ladders out maturities.
Third, there is no Prime derivatives market. This means that no Prime borrower or issuer could efficiently hedge interest rate risk. FASB also does not allow for hedge accounting for the Prime rate index. As a result, all instruments involving hedges of Prime will need to be carried at mark-to-market with no offset on financial statements.
Why is the repo market (and the SOFR index) so volatile?
Repo market levels are driven by supply and demand for cash from major banks, primary dealers and investors. Here are a few examples:
- At year-ends, quarter-ends and month-ends banks are trying to manage capital and liquidity ratios. Consequently, banks which have a need for money on those dates might need to use a higher rate.
- Unexpected need for cash in the markets such as increase U.S. Treasury issuance, Federal Reserve changes in balance sheet or increased cash needs from corporations can lead to spikes in the level of rates that they pay to acquire cash.
Additionally, SOFR levels are driven by actual transactions and there is no smoothing of any temporary increases or decreased in any particular day’s rate levels.
Will the increased adoption of SOFR reduce volatility?
The short answer is no. The increased adoption of SOFR as an index for transactions will not have much effect on the rate levels in repo markets. As discussed in the previous question, supply and demand for cash by banks determines the rate levels that transactions are priced. SOFR is determined based on the level of actual transactions and published the following day.
What can be done to reduce the daily volatility in the repo markets?
The Federal Reserve can act as an additional source of cash for the markets. The New York Federal Reserve Bank (NY Fed) began intervening in the repo and short-term market in September of 2019. The NY Fed’s intervention was driven by a 2.82% spike in repo rates on September 16, 2019. This was the first intervention by the Fed since the financial crisis. As of January 2, 2020, the NY Fed disclosed that the total repo market intervention outstanding was approximately $255.6 billion and the temporary program might extend through April, 2020.
Additionally, changes can be made to the calculation methodologies and required levels for capital and liquidity ratios which might reduce the management of month-end, quarter-end and year-end balance sheet pressures. This would take time to develop and implement.
What is the ARRC’s view on how the COVID-19 pandemic influences LIBOR’s end-2021 expiration date?
The ARRC continues to focus on the established timeline for the transition from LIBOR. The ARRC recognizes that near-term, interim steps may be delayed given the current economic environment with the global pandemic, but given the latest announcements from the official sector reiterating the overall expected timeline, it remains clear that the financial system should continue to move to transition by the end of 2021.
What is the impact of the United Kingdom’s Financial Conduct Authority statement that it could announce the end of LIBOR publication or that LIBOR will be declared "non-representative" sometime later in 2020?
On June 22, 2020, the Head of Markets for the United Kingdom’s Financial Conduct Authority said that they expect LIBOR to continue to be published at least through the end of 2021, but an announcement from the FCA on the cessation of LIBOR could come as soon as November or December of 2020. This announcement would trigger the beginning of the process within many fallback addendums, but not change the LIBOR rate immediately. The possible announcement would giving the market participants one year to prepare for the benchmark to be retired at the end of 2021. Any announcement from the FCA would trigger the calculation of a spread adjustment designed to smooth the transition to a new benchmark for derivatives and cash market contracts that still reference LIBOR.
Vice President, Financial Regulatory Compliance
Jim Shanahan directs CoBank’s regulatory compliance activities, focusing on the treasury function, derivatives transactions, liquidity investments, debt issuance and related financial management activities.
New York Federal Reserve Alternative Reference Rate Committee (ARRC)
- Publications on Floating Rate Notes
- Publications on Syndicated Business Loans
- ARRC Recommendations Regarding More Robust Fallback Language for New Originations of LIBOR Bilateral Business Loans [pdf]
- ARRC Recommendations Regarding More Robust Fallback Language for New Issuances of LIBOR Securitizations [pdf]
- ARRC Releases Recommended Fallback Language for Residential Adjustable-Rate Mortgages [pdf]