LIBOR, the London Interbank Offered Rate, is subjected to transition to SOFR, a Secured Overnight Financing Rate. After continuing a long span of almost 50 years, the benchmark got retired in 2021.
Banks have used this specific interest calculation method to calculate bank-to-bank short-term loans for years. However, the transition was necessary due to unavoidable circumstances and for better banking transactions.
But how can SOFR bring a change? Is it a better decision to evade the LIBOR scandals? To find these answers, we need to dive deeper into knowing the differences between the two. So, this article will help you see the impact of LIBOR on the SOFR transition in CRE.
Key Differences between LIBOR and SOFR
Let’s take a look at the differences between LIBOR and SOFR on the following basis:
- Term rates
Counting on the advantages of LIBOR, LIBOR could be estimated for seven borrowing periods. The period may start from a single day and extend to 12 months. However, SOFR is directly accounted for, and the transactions through SOFR are made overnight.
So, LIBOR’s term rates are forward-looking, and SOFR’s is backward-looking. As a result, contracts need an adaptation when switching from LIBOR to SOFR term rate. The IOSCO and Federal Reserve are continuously working on the calculation method of the term rates.
- Risk-free rate
SOFR is a risk-free transaction based on the Treasury’s overnight transaction. On the other hand, LIBOR involves credit risks as it facilitates bank borrowing.
However, maximum contracts which refer to LIBOR do not require to get involved in such credit risks but have to go through this risk. So, SOFR adjustment is necessary before replacing LIBOR with it to evade the practice of losers or winners while transacting.
Here are some more points of differences between LIBOR and SOFR that should be considered:
- It is an unsecured mode of transaction
- Only a limited transaction can be made with LIBOR as per bank submission and expert judgment panel
- Its term structure is forward-looking
- LIBOR involves credit risks as it features a bank-to-bank lending rate
- GBP, JPY, USD, EUR, CHF, etc., are some of the currency options with LIBOR
- It features daily trading of $500 million within a wholesale funding market of 3 months
- Being associated with the United States Treasuries, SOFR is a secured mode
- It is wholly based on the market transactions
- SOFR is secured and risk-free
- It features daily trading of $1 trillion in the overnight Repo market
- USD is the only currency option for SOFR
- Till 2021 there was no term structure and featured backward-looking, overnight transaction
How does the LIBOR to SOFR transitions affect the CRE
According to the former Director of Lender Relationships at Lev., Brian Hwang, interest rates of maximum CRE loans are LIBOR based. As a result, the transition of LIBOR to SOFR has remarkably affected commercial real estate finance and commercial real estate.
Borrowers should connect with their lender and check for the loan documents carefully if they borrow a LIBOR-based loan. This is because it needs to be written in proper terms and language for a hassle-free transition.
Loan documents are not the same for each transaction; they differ, and usually, every loan document is custom negotiated. So, borrowers can contact the attorney to know about the language written in their loan documents.
Moreover, borrowers should visit the lenders and ensure a seamless transition if they have not received anything from their lender regarding the LIBOR transition and loan documents.
Though many lenders took a step ahead and already connected the borrowers to update their loan documents by adding transition language, the borrowers should take the initiative themselves if anyone still needs to see it.
Hwang also mentioned that if LIBOR is replaced, the transition will be smoother and seamless because the interest rate for both lender and borrower should be theoretically net neutral.
Why is LIBOR retiring?
The largest banks charge one another during loan transactions. The rate of this estimated charge is used to calculate LIBOR, and banks were found rigging these rates in 2012.
Financial industries adopted this rate widely for some historical reasons. For example, this rate is used for financial instruments like price derivatives, cash products, etc.
Some panel banks work on estimating the LIBOR. In 2012, such panel banks cooperated to produce fake estimations to earn more profit from different trades. As a result, interbank loans were not taking place on which LIBOR should be based.
However, panel banks estimated a hypothetical rate based on the amount they lend each other. Moreover, they added uncertain elements to this uncertain estimation. As a result, in 2017, the FCA (Financial Conduct Authority) announced this benchmark would be phased out by 2021.
When will LIBOR switch to SOFR?
Though the LIBOR to SOFR transition deadline was set for 31st December 2021, it has been extended till June 2023.
However, that does not mean any new LIBOR contracts are allowed to make, though legacy contracts are permitted until 2023. This is because “tough legacy contracts” are difficult to transition to SOFR.
So, to resolve this issue, the administrator of the LIBOR benchmark published Japanese yen and synthetic sterling for the tenures of 1,3, and 6 months till 2022. On the other hand, USD legacy contracts will be allowed more time for transition. So, such LIBOR legacy contracts can last till June 2023.
Why does LIBOR transition to SOFR?
Renowned global banks use LIBOR benchmark interest rates to estimate short-term loans lent to other central banks. It indicates the borrowing costs each bank needs to bear due to the lending transactions. This rate can change daily and is calculated through ICE (Intercontinental Exchange).
After being used for more than a decade now, this LIBOR is transitioned to SOFR in recent times. It was previously used to calculate financial contracts’ interest rates, commercial loan transactions, etc.
However, the 2012’s LIBOR scandals made industry experts plan differently. So, they opt for a trusted alternative for a transparent method not based on human panel judgment like LIBOR.
Instead, SOFR is based on transactional market data and a vast measure of the overnight borrowing cost. Moreover, banks use this benchmark to price corporate and consumer credits. It is based on major banks’ interest rates paid for overnight borrowing data, and SOFR is easily accessible as the data is published daily.
Unlike LIBOR, which is based on panel, SOFR is based on market data, and therefore, it is considered more credible and transparent than the former.
Moreover, as SOFR can be easily accessed, it cannot be manipulated by market changes. However, with LIBOR, this problem was inevitable as it was utterly susceptible to market strategies based on human inputs.
So, LIBOR faces several controversies regarding the rates they estimate.
As a result, experts decided to opt for a robust transaction-based SOFR reference rate.
So that it can help reduce the market erosion and financial crisis caused due to LIBOR scandals in 2012. Major banks like Deutsche Bank, Barclays, JP Morgan Chase, Royal Bank of Scotland, Citigroup, etc., manipulated the LIBOR together during the period. As a result, the authorities charged several fines, took regulatory actions, lawsuits, etc.
SOFR could restore the market with its transaction-based reference rates in the future. So, the transition is essential to reduce the manipulation of human-based interest rates.
Banks all across the world are converting to SOFR to stop market manipulation. As a result, CRE investors should keep a close eye on new financial records, which will help them review the changes that influence their finances.
Even though the change has already been enacted, observing the actual effects might take some time.
Moving forward, all new contracts should include a reference to SOFR in place of a LIBOR reference. However, businesses must undertake significant changes to lower their risk exposure for the numerous LIBOR-referencing contracts that mature after 2021.
Although it would be ideal, you shouldn’t constantly renegotiate these contracts to include SOFR. Instead, you should change contracts to contain strong backup language that expressly specifies how and when the benchmark rate will switch to SOFR when it can’t renegotiate.