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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

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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