New year, new reference rate
On December 31, 2021, the financial sector officially transitioned away from the London Inter-Bank Offered Rate (LIBOR) to the Secure Overnight Financing Rate (SOFR). The rates represent the market-determined base (or reference rate) for a multitude of financial transactions. Following scandals surrounding LIBOR rate-fixing and uncertainty in its trustworthiness, the Federal Reserve Bank created the Alternative Reference Rates Committee (ARRC) to study alternatives. After much consideration, the ARRC recommended SOFR, which is “a fully transactions based rate that will have the widest coverage of any Treasury repo rate available [and will] be published on a daily basis by the Federal Reserve Bank of New York… SOFR is a good representation of the general funding conditions of the overnight Treasury repo market. As such it will reflect an economic cost of lending and borrowing relevant to a wide array of market participants active in these markets, including broker dealers, money market funds, asset managers, insurance companies, securities lenders and pension funds” per the Fed.
Given the lengthy lead time for the transition and the guidance provided by the ARRC, this news is not novel and the financial system is well-equipped to manage the transition. However, it does signal the end of an era and a strong step toward increasing market efficiency and participant trust.