The Federal Reserve Board adopted a rule that will officially set the Secured Overnight Financing Rate (SOFR) as the benchmark rate in financial contracts that reference the expiring London Interbank Offered Rate (LIBOR).
The Fed’s rule, adopted Friday, will take effect 30 days after publication in the Federal Register. It will apply to affected financial contracts after June 30, 2023, when U.S. dollar LIBOR panels end.
SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. Congress in December 2021 enacted the LIBOR Act, which ordered SOFR replace overnight, one-month, three-month, six-month, and 12-month LIBOR benchmark rate in contracts subject to the act. The law also stipulated LIBOR contracts adopting a benchmark rate selected by the Fed will not be interrupted or terminated following LIBOR’s replacement.
LIBOR, published by the U.K.’s Financial Conduct Authority (FCA), served as the financial benchmark for more than $200 trillion worth of contracts worldwide. It reflected the rate at which large banks can borrow wholesale funds on an unsecured basis. But the rate proved “fragile and subject to manipulation,” as the Fed stated in its press release, a nod to the reasoning behind the FCA ceasing to support the rate beyond 2021.
Other rates had been proposed to replace LIBOR as the benchmark rate, including the Bloomberg Short-Term Bank Yield Index (BSBY). But U.S. regulators concluded BSBY had some of the same weaknesses as LIBOR.
“Certain alternatives being considered in the markets … present many of the same flaws as LIBOR: thin markets—in times of stress scantily-clad—with few underlying transactions, creating a system vulnerable to collapse and manipulation,” said Gary Gensler, chair of the Securities and Exchange Commission (SEC), in remarks before the Financial Stability Oversight Council on Friday. Term SOFR, Gensler said, “are truly deeply, liquid, and fully clad.”
Regulators, including the Fed and the SEC, began warning financial institutions, broker-dealers, and investment advisers to include fallback language in their contracts that referenced LIBOR in 2017. Those calls increased as LIBOR was set to expire.
The Commodity Futures Trading Commission set SOFR as the benchmark swap clearing rate for swaps denominated in the U.S. dollar with a rule it announced in May. Certain swaps will be allowed to reference LIBOR until July 1, 2023.