Discussion Post 3: Module 3 FIN4345
Read each post and write a paragraph replying to each one giving your opinion
First Post: Why is LIBOR been replaced?
The London interbank offered rate (LIBOR) is being replaced by the secured overnight financing rate (SOFR). SOFR is preferred over LIBOR since it is based on data from observable transactions instead of estimated borrowing rates. One of the historical events that contributed to the need for this change is that global market has grown in size and complexity while LIBOR methodology has remained largely unchanged. Interest rate swaps on 80 trillion dollars switched to the SOFR in October 2020 making the transition a reality. The long-term goal is to increase liquidity but in the short term it can have a great impact on trading volatility in derivatives. The transition of financial institutions has been slowly; however, it is possible that at this rate LIBOR will end before 2021. Banks are considering value-transfer risk, and assessing contract and portfolios maturing after 2021.
Second Post: What are the key differences between SOFR and LIBOR?
There’s been a slow attempt to transition from LIBOR (London Interbank Offered Rate) to SOFR (Secured Overnight Financing Rate) since 2012, when it was found that some banks were falsifying information to influence the LIBOR rate. Essentially, the LIBOR rate is calculated based on the rate that banks charge each other for loans, or the wholesale unsecured price for inter-bank lending. However, since there were some banks that weren’t actually lending money to each other, this rate wasn’t fully based on transactions that were actually taking place. The SOFR is offered as a solution to this, where the SOFR rate is actually based on loans that are closed, and less likely to be influenced by bank manipulation.
However, there are some differences between the two rates that haven’t been accounted for in this switch. The LIBOR rate can be made for several borrowing periods, while the SOFR rate only covers overnight lending transactions. Therefore, there are a lot of calculations and adjustments to account for in switching the rates. Another difference is that the SOFR will be considered a riskless rate, whereas the LIBOR includes the credit risk involved when borrowing from a bank. Additionally, on the whole, SOFR is historically lower than the LIBOR rate. The LIBOR rate also represents an unsecured rate while the SOFR represents a secured one. Lastly, the LIBOR rate is representative of $500 million in underlying transactions while the SOFR has $1 trillion in underlying transactions.
A useful lesson from this is definitely that even banks can work in corrupt manners to influence interest rates. Essentially, this was to their gain since customers would pay the LIBOR rate, or LIBOR plus additional basis points. Therefore, the banks were working to increase their own interest income, so as consumers it’s good to be aware of these types of practices.