Quantifi, a provider of risk, analytics and trading solutions, has today announced the release of its latest whitepaper ‘Farewell LIBOR, Hello SOFR: Analytical Hurdles, and Fixed Income Implications’. The paper looks at how the transition from LIBOR to SOFR impacts rates, bonds, and loans. It also explores the challenges the transition has presented to the market.
The London Inter-Bank Offered Rate (LIBOR), in operation for over 50 years, was once considered the global benchmark for short-terms interest rates. However, mounting integrity concerns and a decline in underlying transactions, prompted regulators to seek a more robust alternative. In 2017 the ARRC (Alternative Reference Rates Committee) in the United States identified SOFR (Secured Overnight Financing Rate) as the preferred alternative to LIBOR. The transition from LIBOR to SOFR poses several challenges. Unlike LIBOR, which represents unsecured lending between banks, SOFR reflects secured overnight lending backed by collateral. The transition required adjustments to account for differences in risk and tenor.
The main hurdles in transitioning from LIBOR to SOFR are the fundamental difference between the two rates (forward-looking vs. overnight) and the need for increased liquidity in the SOFR derivatives market. This disparity required market participants to adapt their pricing and risk models to accommodate the new rate methodology. Another challenge highlighted in the paper is the impact of the new SOFR rate effect on floating bonds and loans. Replacing the LIBOR term rate with daily SOFR rate, paid in arrears, complicates coupon calculation. As SOFR is quoted daily, it might not be available on the loan payment day, making timely coupon calculation and payment preparation difficult.
“While the deadline for publishing USD LIBOR rates passed on June 30th 2023, the challenges associated with adopting SOFR as a replacement rate persist. These challenges encompass analytical, computational, and operational aspects.,” comments Dmitry Pugachevsky, Director of Research, Quantifi. “To address these challenges, organisations must develop a robust analytic library and possess strong operational capabilities. This can be achieved either through in-house development or by employing third-party solutions, such as Quantifi, to enhance the necessary functionalities,” continues Dmitry.