Difference Between LIBOR & SOFR and Why You Must Know This

If you’re preparing for a career in #salesandtrading or #corporatebanking, including preparing for interviews, you must know about the London Interbank Offered Rate (LIBOR) and Secured Overnight Financing Rate (SOFR). It’s considered basic information that is very important for tracking base rates, especially when dealing with debt instruments, and derivatives like interest rate swaps or currency swaps. 

Published daily by the Intercontinental Exchange (ICE), #libor was used as the benchmark interest rate at which major global banks lent to one another in the international interbank market, covering over $200 trillion in mortgages, derivatives, business loans, and other financial contracts worldwide. However, with the U.S. Federal regulators have pushed for LIBOR to be phased out by the end of 2021 since it is not as reliable for various reasons:

💡 With the reduction in the unsecured bank funding activity, LIBOR cannot be a reliable representation of market activity 

💡 Since LIBOR is based on banks’ estimates rather than actual transactions, it is prone to manipulation, hence not sustainable.

 

SOFR emerged as a credible alternative as its estimations are based on observable trades in the repo market. Other overnight risk-free rates (RFRs) that were considered included SONIA (Sterling Overnight Index Average) in the United Kingdom and TONA (Tokyo Overnight Average Rate) in Japan. #sofr represents the average rate that US banks borrow from investors overnight (to meet liquidity requirements) using US treasury bonds as collateral.

Experts predict some short-term volatility on interest rate swaps/options as several of these financial products would switch from LIBOR to SOFR, although a sustained long-term impact isn’t expected. Debt quotes will witness a shift from being based on SOFR instead of LIBOR so you should be extra mindful of the new rates while supporting related sales roles. 

 

Although trading in SOFR was initially tepid, transaction volumes underlying SOFR have been reported around $1 trillion in daily volumes. The transition is a complex consideration that involves various risks emerging from the LIBOR being ousted as a key reference rate for markets. But the repo market’s large transaction volume makes SOFR a reliable choice that may be more adaptable to various market conditions, making it a good long-term option to replace LIBOR.

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