Analysis SOFR vs LIBOR

For our analysis on the two benchmarks rates SOFR and LIBOR, we will do in-depth
research on both rates in terms of their difference, similarities, challenges, factors, investment
risk and provide our own opinion at the end of the analysis.
Key Difference between SOFR and LIBOR
First of all, we shall list out several key difference between SOFR rates and LIBOR rates to
provide a clearer picture on the reason behind the shift from LIBOR to SOFR.
SOFR LIBOR
Risk Free rate (no credit risk) Bank to bank lending rate (include credit
risk)
Secured Unsecured
Backward looking Forward Looking
No term structure Term structure
Transaction Based Based on expert judgement
Based on $1 Trillion transaction (per day) Based on $1 Billion Transaction (per day)
Figure 1: Summary of the differences between SOFR and LIBOR
Figure 1 above summarizes the key difference we have identified during our research on
SOFR and LIBOR. In sequence, we will explain each difference between the two rates and
attached relevant graphs to support our topic.
1. Risk Free rate vs Bank to bank lending rate
Bank to bank lending rates is an interest rate which banks charge when they lend to other
banks. Most often is the interest rate on short-term loans they lend to other banks. Normally,
banks borrow money from each other for the purpose of covering deficiencies in their
reserves. Bank rates can be used as benchmark rates as it is able to affect consumer lending
rates. This is because banks charge rates close to their bank lending rates for loans lent to
their most creditworthy customers (Kenton, 2019).
The London Interbank Exchange Rate, or commonly known as LIBOR is one the most used
bank to bank lending rate. What makes LIBOR a bank to bank lending rate? On each day the
Intercontinental Exchange (ICE), ask major banks around the world on how much they would
charge other banks for short-term loans. Then they would calculate the average from the
numbers they received after excluding the highest and lowest figure. The reason behind this
method of calculation is because they wish to match the risk of the asset (loans) with the risk
of the liabilities (assumingly borrowings from other banks) (Chen, 2020).
According to Nakaso, LIBOR represents the average borrowing cost of a bank. As such, it
incorporates a built-in credit risk component, that reflects the expected common credit risk of
the sample banks contributing their reference rates. In addition, LIBOR rates that
incorporates credit-risk also has implications for monetary policy and financial stability. In
terms of monetary policy, LIBOR rates are always ensured to be in tandem with the
movement of policy rates. Then for its implication in financial stability, LIBOR has the
ability to transfer funding cost risk form lender to borrower. This can enhance risk allocation
to the extent where end-borrowers can manage these risks. Therefore, they can maintain
financial stability.
In simple terms, risk-free rate is the rate of return of an investment with zero risk. It
represents the amount of interest one would receive from a risk-free investment over a certain
period of time (Chen, 2020). Since it is the minimum amount of return an investor expects, it
could be used as a benchmark rate. Risk-free rate is the foundation for every type of
investments, it serves as the lowest threshold other investments must exceed in order to have
value. In the US, three-month U.S. Treasury bills are used as the main reference for risk free
rates (Borad, 2018).
Meanwhile, SOFR represents a risk-free rate as it based on treasury. In detail, SOFR is used
to measure the overnight cost of borrowing based on repo transactions that are collateralized
with U.S Treasury Securities. The repo market is the deepest and most liquid money market
in the US. As such, SOFR is able to reflect an economic cost of lending and borrowing
relevant to the various market participants. In addition, as SOFR is based on transactions in
liquid markets it is able to become proxies to risk-free rate and have no credit premium
(Held, 2019).
2. Secured Vs Unsecured
The term secured refers to anything that is backed by collateral, whether it is assets, loans or
even benchmark rates. Collaterals are very impactful in the event of a default, the party which
the collateral is pledge to has the right to sell it and use the proceeds to compensate for their
loss. This decreases the overall risk of the secured product (Chen,2020).
The topic rate of our research SOFR, is measured based on repo transactions collateralized
with U.S Treasury Bills (Held, 2019). Repo is a form of collateralized short-term loans,
which the borrower pledges a security as collateral while entering into an agreement to
repurchase it at an agreed price in the future. In the case of SOFR, Treasury Repos is an
important source of funding for dealers in government securities. Normally, they will pledge
treasuries as collateral to raise cash. Hence comes the statement that SOFR is a secured rate.
In turn, SOFR can be expected to be more volatile as it is based on repo markets. Conditions
on collateral markets and dealer balance sheet can also cause SOFR to be volatile. SOFR has
tended to trade above the predetermined range set by the Rate of Remuneration on Bank’s
Excess Reserves (IOER) and the Rate on the Federal Reserve’s Overnight Reverse Repo
Facility (RRP) (Schrimpf & Sushko, 2019). IOER and RRP bounds the effective federal fund
rate (EFFR), which is the benchmark rate where banks refer upon when lending their excess
reserves to other banks (Chen, 2020).
 Figure 2: Comparison of US dollar, Sterling and euro overnight rates
As compared to SOFR, LIBOR is an unsecured rate. It reflects the interest rates offered in the
interbank unsecured lending market (Sontag & Stone, 2019). At times of market stress, we
can expect SOFR to compress, while LIBOR is likely to spike. Banks using assets linked to
LIBOR rates can better manage their interest rate risk as higher payments of these assets can
help offset the pressure from increased funding cost (Plesser & Browne, 2019). However, the
unsecured interbank lending market today is not liquid or active enough to produce a reliable
reference rate. This leads to the ICE shifting to use the “expert judgement” from sample
banks to calculate LIBOR, which caused LIBOR to be subjected to vast misconduct and
manipulation (Sontag & Stone, 2019).

3. Backward Looking vs Forward Looking

In order for SOFR or other overnight rates to replace LIBOR as fallback rates, they must first
become term rates. At the moment there are two main approaches the ISDA and national
regulators are considering to ensure smooth transition from LIBOR to its replacement rate.
The first approach is compounded setting-in-arrears rate (backward looking rates), which is
known at the end of the corresponding application period. The second approach is a market
implied prediction of this compounded in-arrears rate, which resembles forward looking rates
and is known at the beginning on the corresponding application period. Backward looking
rates define new RFR futures and vanilla swaps, whereas forward looking rates is more
preferable when it comes to defining fallbacks for cash products (Lyashenko & Andrei &
Mercurio & Fabio, 2019).
By default, the easiest method to obtain a term rate is to construct it from past realisations of
overnight rates. For example, the compounded setting-in-arrears methodology used to
compute backward looking rates. The relevant authorities will use the compounded O/N Risk
Free Rates over a particular to determine the interest payment obligation over the same
period. However, SOFR rates which is based on compounded in arrears cannot be fixed until
the end of the period. As shown in Figure 3, borrowers and lenders can only know know the
precise interest payment just a few days before the period ends (Kelley, 2020). This method
is feasible only when the full realization of O/N rates is known at the end of that period. As
such, the topic of our research SOFR is a backward-looking rate. One of the advantages of
backward-looking rates is that these rates can still be computed even without underlying
transactions in term instruments or in derivatives. However, the structure of backward-
looking rates made it unable to reflect expectations about future interest rates and market
conditions (Schrimpf & Sushko, 2019).

Figure 3: Methodology behind compounded SOFR

In contrast, forward rates like LIBOR is known at the beginning of the period to which they
apply as shown in Figure 4. For borrowers and lenders using LIBOR, they are able to know
the interest payment amount at the start of the period when the rate is fixed (Kelley, 2020).
This is because LIBOR is an outcome of market-based price formation process, market
participants’ expectations about the future interest rates and market conditions are embedded
during the computation of LIBOR. Therefore, interest obligations are paid or received at the
beginning of the term over which that rate applies for financial instruments based on LIBOR.
An advantage of forward-looking rates is that many market participants value this certainty
for budgeting. In addition, our current operational system in cash markets still relies on such
rates (Schrimpf & Sushko, 2019).

Figure 4: Methodology behind LIBOR

The Financial Stability Board encourages all market participants to use overnight rates rather
than forward-looking rates as the liquidity of overnight markets is growing. Meanwhile, the
ARRC recommends a forward-looking term rate. As for the derivatives market, the
International Swaps and Derivatives Association (ISDA) conducted a consultation on this
topic. The results show that market participants prefer forward-looking rates compounded in-
arrears for RFRs rather than backward-looking rates compounded in advance (CathCart &
Stubbe, 2020).
According to a research by Lyashenko and his colleagues, they showed that backward-
looking rates are able to replace IBORs form the analytics perspective. They believe that
backward-looking rates not only have the analytical properties of IBORs, but they also have
some others IBORs are lacking. As such they were able to show that the foundation of the
classic interest-rate modeling framework is preserved and further enriched if we were to
switch from forward-looking to backward-looking rates (Lyashenko & Andrei & Mercurio &
Fabio, 2019).
5. Term vs No-Term Structure
Term structure of interest rates is one the most important aspects in finance, especially in the
bond market. It is the relationship between interest rates or bond yields and different term
maturities. As such, term structure of interest rates is able to reflect the expectation of market
participants about future changes in interest rates. Along with the direction of yield curves, it
can be used to judge the overall credit market environment (Chen, 2020).
Moving on to our main topic, SOFR currently is just an overnight rate which does not have
multiple maturities (Deichler, 2018). This means that there will limitations in using SOFR
namely in the case of volatility. To counteract this issue the Federal Reserve have started to
publish 30, 90 and 180-day SOFR averages, or compounded SOFR we talked about in the
section before. As we can see in Table 2 below, overnight SOFR rates are extremely volatile,
but compounded SOFR remains relatively stable. However, it is still unclear whether the
Federal Reserve will develop forward-looking term SOFR, which would be beneficial for the
syndicated loan market (CathCart & Stubbe, 2020).

Table 2: O/N SOFR and Compounded SOFR

On the other hand, LIBOR have seven varying rates on terms, namely overnight, one week,
one-month, two-months, three-months, six-months, and one-year (M.Stanley, 2019). Given
that it has such a wide range of maturities, it remains the most suitable rate for treasurers who
currently borrow at one month, three months, etc (Deichler, 2018).
6.1 Transaction Based vs Based on expert judgement
The definitive foundation of SOFR and LIBOR is one of the most impactful difference
between both rates. SOFR is based entirely on transaction data, while LIBOR is based
partially on so call “expert judgement” (M.Stanley, 2019).
Starting with SOFR, not only it is based on actual transactions, it also takes in more
transactions than any other Treasury Repo rate in the market (Held, 2019). As stated above,
SOFR is determined based on transaction data, which includes tri-party agreements (repo),
General Collateral Finance (GCF) repo and Bilateral Treasury repo transactions cleared
through the Fixed Income Clearing Corporation (FICC). As a result, SOFR became a good
representation of general funding conditions in the O/N Treasury repo market. So it is able to
reflect the economic cost of lending and borrowing relevant to a wide-array of market
participants (Schrimpf & Sushko, 2019). Other than that, SOFR is derived from an active and
well-defined market (Treasury Repo Market), which gave it sufficient depth so that it is
difficult to manipulate. During the Global Financial crisis, the treasury repo market was able
to remain relatively stable. This gave the ARRC confidence that rates based on this market
(SOFR) can remain reliable in various market conditions (ARRC, 2019).
Meanwhile, LIBOR which is based on “expert judgement” is being called a design flaw. The
rate is constructed from a survey of a small set of sample banks reporting their non-binding
quotes rather than actual transactions. This caused LIBOR to be subjected to manipulation
from panel banks (Schrimpf & Sushko, 2019).
6.2 Transaction Volume
Looking at the transaction volume of the underlying markets of both rates, the volume of
SOFR dwarf the volume of LIBOR, not to mention many other overnight rates like the
overnight bank funding rate (OBFR) and overnight rates covering the federal funds market
and Eurodollar Market (Schrimpf & Sushko, 2019). The transaction volume of the underlying
market of SOFR is around $1 trillion a day (Held, 2019). As for LIBOR, their underlying
markets only has around $ 1 Billion Transactions per day (Kelley, 2020).
Similarities Between SOFR and LIBOR
The main aspect SOFR and LIBOR have in common is the use of both rates. Both rates are
important reference rates used by many market participants. Up until today, various financial
instruments like derivatives, loans and securities still rely on both SOFR and LIBOR for
pricing (Schrimpf & Sushko, 2019).
Next, both SOFR and LIBOR has the capability to serve as a benchmark for term lending and
funding. This is due to the fact that financial intermediaries play the role of lender and
borrower. As such, their need benchmark rates that is in sync with the rates at which they
raise funding (Schrimpf & Sushko, 2019). In this case, SOFR which represents the average
rate on Treasury repos and LIBOR which represents bank to bank lending rates fulfill the
requirements to become benchmark rates (Chen, 2020).
Challenges of SOFR to LIBOR transition
Since, the announcement from FCA came out stating that LIBOR will end in 2021, various
challenges has emerged. Many see the advantages of using SOFR to replace LINOR, but as
they look deeper into the topic, they soon realise significant challenges of shifting from using
unsecured forward terms rates (LIBOR) to secured overnight rates (SOFR) (Schrimpf &
Sushko, 2019).
These challenges include:
i) Currently, forward term SOFR has yet to be developed. Due to insufficient liquidity in
SOFR futures and OTC derivatives markets, the market in unable to facilitate the
development uf SOFR-based forward curves (Chatham Financial, 2018). Any activity that
requires forward-looking rates are stuck to using LIBOR (Deichler, 2018). In addition,
borrowers and lenders will need to wait until the end of each interest period to know the
given interest payment for that period (Schrimpf & Sushko, 2019).
Furthermore, many end users are still accustomed to calculating LIBOR-based cash flows
which are in advance of payment. Therefore, they will need to develop new technology,
procedures and infrastructure to support this change in calculation of cash flow (Chatham
Financial, 2018).
ii) We lack the method to calculate the amount of spread that will be added into SOFR, to
account for the credit risk premium associated with LIBOR (Schrimpf & Sushko, 2019).
Proper spread adjustment will be needed to minimize the “value transfer” in the transition
form LIBOR to SOFR. If not properly managed, end-users may find themselves worse off
economically by virtue of the transfer (Chatham Financial, 2020).
iii) Reports show that banks are having issues changing their operation systems as well as
loan documentation to accommodate the compounded in-arrears computation method of
SOFR (Schrimpf & Sushko, 2019). The most direct issue financial institutions will face is
that they will be required to amend their loan and derivates documentation to suite the new
rate. However, they lack the consistency in language across financial products or even the
same financial product. This made the situation very difficult for end users to manage the
differences in fallback language across products and counterparties (Chatham Financial,
2020).
Another challenge concerning fallback language is from the recommended fallback language
issued by ARRC and ISDA. It has a risk of producing inconsistent outcomes between loans
and the derivatives designed to hedge them. This is a problem for end users as they will risk
being unable to align hedges with underlying risks and eliminate basis risk (Chatham
Financial, 2020).
According to a report by Chatham Financial, they found out that certain retail products are
having difficulty accommodating to a transition from LIBOR to SOFR. These products
include student loans, residential mortgages, etc. As a result, holders of loans linked to these
financial products risk economic impact they never contemplated when purchasing. In which
also subjects the issuers and trustees of these loans to litigation risk.
 
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