Starting in 2021, the most widely-used interest rate benchmark, the London Interbank Offered Rate (LIBOR), will cease to exist as the reference rate for an estimated $200 trillion in USD-denominated derivatives and loan contracts. Consequently, nearly every US-based investor or borrower paying down debt tied to LIBOR rates will be affected by the change.
Facilitating the transition in the US is the Alternative Reference Rates Committee (“ARRC”), a Federal Reserve-sponsored panel of private- and public-sector stakeholders tasked with determining the country’s new reference rate and coordinating change management for US industry. As of August 1st, the new reference tapped by the ARRC to serve as the preferred replacement to LIBOR is known as the Secured Overnight Financing Rate (SOFR).
Financial experts in government as well as industry broadly view SOFR as a more realistic benchmark than LIBOR, because SOFR is actually driven by daily debt market transactions, and is considered to be less susceptible to the manipulation that scandalized LIBOR during and after the financial crisis. In contrast to LIBOR, which was developed daily based on the collective opinion of London’s banking sector, SOFR is derived from the rate investors pay to borrow cash overnight using U.S. government securities as collateral, trades known as overnight purchase agreements or “repos.”
The important takeaway for US businesses is two-fold:
- Given that LIBOR is so widely-used as an index that almost every type of loan, line of credit, or financial product relies on the current LIBOR regime to some extent, the transition to SOFR is likely to affect the amounts of interest paid for floating rate instruments.
- On the accounting front, businesses should follow the developments of the Financial Accounting Standards Board (“FASB”) as they consider implications on contract structures and changes to hedge accounting during the transition. While FASB recently released an update to its Reference Rate Reform project, final guidance is expected to arrive in early 2020.