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The Federal Reserve’s Alternative Reference Rate Committee (ARRC) selected the Secured Overnight Financing Rate to replace USD LIBOR, the main reference rate used in credit instruments in the U.S. With more than $200 trillion of financial instruments based in USD LIBOR, the transition to an alternative reference rate should be followed closely.
This page features some educational materials and resources to learn more about LIBOR and potential changes coming to the industry.
LIBOR (London Interbank Offered Rate) is an estimate of the cost of borrowing/lending for banks on an unsecured basis. The rate is determined each day based on rate submission from panel banks.
U.S. Dollar LIBOR is the dominant reference rate for financial instruments, particularly floating rate loans. The size of the contracts indexed to U.S. Dollar LIBOR is estimated to be more than $200 trillion. Many floating rate loans in the rural agriculture and rural infrastructure sectors currently use U.S. Dollar LIBOR as a reference rate.
U.S. and international banking regulators have been expressing concern about LIBOR over the past several years. The primary concern is that the lack of a deep and liquid market in unsecured intra-bank transactions has reduced the reliability of LIBOR as an index and the market needs to transition to an alternative reference rate for floating rate transactions.
Beginning in 2022, the United Kingdom’s Financial Conduit Authority (LIBOR’s primary regulator) will no longer compel banks to submit estimated rates and there is concern that publishing of LIBOR will not continue beyond 2022.
The Federal Reserve convened the Alternative Reference Rate Committee (ARRC), which has recommended the creation of an alternative called the Secured Overnight Financing Rate (SOFR) as a replacement benchmark rate. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities and is completely transaction based. The Federal Reserve Bank of New York began publishing SOFR trading data on April 3, 2018.
Financial market industry workgroups, regulators and fixed income market participates will be working to develop the new SOFR markets and the process for transitioning to it. SOFR futures and swaps are now in existence and some cash instruments have also been issued.
The market has yet to determine the timing and the adjustments that will be made to the existing LIBOR transactions in order to minimize any transfer of value.
The team at Farm Credit Mid-America has been working closely with several Farm Credit institutions, industry groups and financial regulators about the transition of LIBOR as a benchmark rate. It is expected that LIBOR will continue to be in use through 2021 for existing loans, though we are transitioning many of our customers’ loans off of LIBOR now in 2020. During the fourth quarter of 2020, the removal of LIBOR product offerings will begin and SOFR products will be introduced as they are made available.
Repo market levels are driven by supply and demand for cash from major banks, primary dealers and investors. Here are a few examples:
Additionally, SOFR levels are driven by actual transactions and there is no smoothing of any temporary increases or decreased in any particular day’s rate levels.
The short answer is no. The increased adoption of SOFR as an index for transactions will not have much effect on the rate levels in repo markets. As discussed in the previous question, supply and demand for cash by banks determines the rate levels that transactions are priced. SOFR is determined based on the level of actual transactions and published the following day.
The Federal Reserve can act as an additional source of cash for the markets. The New York Federal Reserve Bank (NY Fed) began intervening in the repo and short-term market in September of 2019. The NY Fed’s intervention was driven by a 2.82% spike in repo rates on September 16, 2019. This was the first intervention by the Fed since the financial crisis. As of January 2, 2020, the NY Fed disclosed that the total repo market intervention outstanding was approximately $255.6 billion and the temporary program might extend through April, 2020.
Additionally, changes can be made to the calculation methodologies and required levels for capital and liquidity ratios which might reduce the management of month-end, quarter-end and year-end balance sheet pressures. This would take time to develop and implement.
The ARRC continues to focus on the established timeline for the transition from LIBOR. The ARRC recognizes that near-term, interim steps may be delayed given the current economic environment with the global pandemic, but given the latest announcements from the official sector reiterating the overall expected timeline, it remains clear that the financial system should continue to move to transition by the end of 2021.
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