Fed Launches SOFR: Alleged Replacement for $350 Trillion LIBOR Market

Mish

The Fed hopes to move contracts to SOFR, away from the volatile, yet massive LIBOR market.

First Steps

A Libor Replacement Project is underway.

Regulators around the globe began work on replacements for Libor, the London interbank offered rate, well before the U.K.’s Financial Conduct Authority sought to put the beleaguered interest-rate benchmark out of its misery. In the U.S., enter the Secured Overnight Financing Rate, or SOFR, a new reference rate introduced Tuesday by the Federal Reserve Bank of New York in cooperation with the U.S. Treasury Department’s Office of Financial Research. The debut of SOFR is a critical step in a quest to wean more than $350 trillion of securities off Libor.

Why Replace Libor?

For decades, Libor provided a reliable way to determine the cost of everything from student loans and mortgages to complex derivatives. It’s derived from a daily survey of about 20 large banks that estimate how much it would cost to borrow from each other without putting up collateral. Because fewer banks make such unsecured loans, Libor was becoming more theoretical than real. That was vastly compounded by the discovery of rampant manipulation by U.S. and European lenders that were forced to pay billions of dollars to settle rigging and other charges. All this is why the FCA pledged to stop compelling firms to provide estimates by the end of 2021, and why regulators around the world are rushing to establish alternatives.

How is SOFR Different?

Where Libor relied on the expectations of bankers, SOFR is based on real transactions from a swath of firms including broker-dealers, money-market funds, asset managers, insurance companies and pension funds. It’s different from Libor as well in that it’s a secured rate, since the repo rates it’s derived from are collateralized, or backed by assets. It’s an overnight rate, based specifically on overnight loans; Libor, by contrast, covered loan maturities ranging from one day to one year. And the volume of trading underpinning SOFR is significantly larger: In 2017, it regularly exceeded $700 billion daily, versus an estimated $500 million for three-month dollar Libor, according to ARRC data.

SOFR Launch

Reuters reports New York Fed launches U.S. Libor Contender, Slow Takeup Seen

Publishing the rate is the first step in a multi-year plan to transition more derivatives away from the London interbank offered rate (Libor), which regulators say poses systemic risks if it ceases publication.

Analysts have struggled to explain a recent jump in Libor, which has reached nine-year highs even as bank credit quality is seen as solid.

A move away from Libor, however, is expected to be gradual and complicated. One issue is that there is not yet a market for term loans such as one and three months, as in Libor.

“It’s hard to imagine a way they could come up with a similar calculation for a term rate and that’s the big difference between whether or not people would be comfortable adopting SOFR as a straight replacement for Libor,” said Thomas Simons, a money market economist at Jefferies in New York.

Fraud vs Manipulation

Where's there's a staggering $350 trillion market that is not based on real transactions, there's guaranteed to be outright fraud.

The replacement product will be controlled by the Fed. Instead of lies and fraud, look forward to more Fed manipulation, especially at critical junctures.

Mike "Mish" Shedlock

Comments (7)
No. 1-7
Carl_R
Carl_R

Anything would have to be an improvement.

Hooligan
Hooligan

hypocrisy much? price rigging/fixing is illegal and yet central banks engage in it.

Blacklisted
Blacklisted

You can put lipstick on a pig, but it won't stop rates from rising. A doubling of LIBOR/SOFR by 2020 is likely, and once it's over 5% all hell will break lose.

Roger_Ramjet
Roger_Ramjet

As far as lies and fraud, that would be easy to curtail by instituting (and actually prosecuting) law breakers with harsh prison terms and extremely punitive fines. After a few jaw-dropping sentences, I would bet that the problem would be fixed fairly quickly. No need to disrupt an already massive $350 trillion securities market.

BornInZion
BornInZion

The more things change, the more they stay the same. In 700 BC a poem was written that described their lawless society that loved lies just as we Americans do now. It is in the book of Isaiah chapter 59.

Cbb
Cbb

I think this new move by the FED is totally related with the new jump in Libor Rates, it started to hit the markets badly, they want to eliminate that risk before it is out of control.

Ambrose_Bierce
Ambrose_Bierce

Only they have been working on this for a while, but SOFR is being used as monetary propaganda to dispel the fear of a credit squeeze. SOFR is based on REPO markets which are keyed to Fed interest rate guidance, so it's jawboning on steroids. The Fed has proven it CAN"T HANDLE THE DATA. They set an employment benchmark, blew it off, set an inflation benchmark, promised to raise it when they couldn't hit that number, the Fed and data are like oil and water. The problem should they lead markets to a particular conclusion and they do not follow that script they will set markets up for a shock. Also consider the Fed as an appendage of USG must prepare the markets for a massive monetization of government bonds, and the money must come from (reallocate) somewhere. NYSE?


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