Libor era nears end, firms move to SOFR for financial contracts

Libor, the London Interbank Offered Rate, is expiring soon. Yahoo Finance’s Brian Cheung explains the transition away from this reference rate and what it means for markets.

Video Transcript

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JULIE HYMAN: LIBOR, the London Interbank Offered Rate going away. Brian Cheung is here to tell us why you should care about this. LIBOR is a pretty technical financial instrument but it's one that sort of underpins a lot of other things within the financial system.

BRIAN CHEUNG: Yeah. Certainly, and you know what they say, new year, new interbank reference rate change. And that's certainly the case when we do have the new year in 2022, there's going to be a new reference rate on the Street. But first, let's kind of give a little bit of a primer on exactly what LIBOR is. I promise this isn't a full Yahoo U, but basically, this is a reference rate that banks decide on for short-term borrowing from one another. Now, financial contracts for derivatives and things like even loans are also pinned to the LIBOR rate. And the maturities for these rates will range from overnight, to as long as 12 months but again, it's still primarily a short-term reference rate.

Now, people will recall that there was a big scandal out of the financial crisis around 2012 where banks were gaming LIBOR because, for the most part, it's a self-reported rate. So the regulators basically around the world after the fact, said we need to get rid of this, we need to replace it with something. So the game plan is to phase it out across financial contracts in 2023 but the phase-out is going to begin with some contracts this year, one week and two month LIBOR will phase out effective on Saturday. And then overnight, 12 month, other duration contracts will phase in by the end of June 2023.

Now, the replacement in most cases is going to be what they call the Secured Overnight Financing Rate or SOFR. This is a rate that the Fed itself actually made, which hopefully should get rid of the gamification that maybe some of the banks that were using LIBOR were doing improperly. So the question naturally is if some of the phase-in is supposed to happen in two days, well, what's the progress update on how we're doing? Well, the statistics show that as of around late October, around 80% or more of inter-dealer linear swap risks were now already tied to the new rate, again of SOFR. So pretty good on that front.

When you take out loans, for example not so much because a lot of lenders said they might prefer something that's a little bit more credit sensitive. And in fact, JD Supra and Bloomberg data actually shows that corporate loan volume that's tied to LIBOR increased over the latter parts of 2021. And one challenge is that regulators have really made this more of a recommendation than a requirement. There's no kind of legal clarity in terms of whether or not it's compulsory for firms to make these contract changes beyond regulators encouraging them to do so.

One way that they tried to do that, the New York Fed has tried to use Twitter. They've tried to make some memes try to make this as exciting as they possibly can as is the case with LIBOR in this transition. So they posted a meme earlier this week that said, so fresh, so clean, referencing the Outkast 2001 song from 'Stankonia' trying to get banks to make that transition over to SOFR, you get it because SOFR, so fresh, so clean? Anyway, that's how the transition is going, guys.

BRIAN SOZZI: I got-- yeah, I got it, Brian. Your excitement over LIBOR is infectious. I'm going to go bang out a hundred push-ups. But real quickly, should investors expect any shake-ups in certain markets as this thing transitions?

BRIAN CHEUNG: Probably not. I mean, that's because a lot of these financial contracts like I mentioned, especially in the derivatives space, have already been ported over to alternative rates. But watch the loan space, collateralized loan obligations, and other types of leveraged loan products because again, they've been a little bit more sensitive to making the transition to SOFR because they want to have something that's a little bit more flexible around the credit risk. We showed that chart of SOFR earlier, it's a very more static rate than LIBOR is. So that's definitely something that's going to be worth watching.

But financial regulators have said it could be a financial stability risk if these contracts don't move over to alternative rates fast enough. Now, that might just be a scare tactic to get the contracts to port over again because it's more of a recommendation than a legal statutory requirement. But again, 2023 we have until for a lot of these contracts to port over. So we'll get another status update and maybe a few more memes when we get closer to the end of June 2023.

BRIAN SOZZI: All right, LIBOR beat reporter, Brian Cheung. Thanks so much. Talk to you later.