The London Inter-Bank Offer Rate (LIBOR) reference rate has announced its retirement and 31st December, 2021 will be the last day of its service. It is estimated that contracts worth $350 trillion will be impacted by this transition. Financial institutions are now forced to repaper their contracts to remove LIBOR references. Alternative Reference Rates (RFR) such as SONIA and SOFR have the spotlight now because people are actively looking for the transition to happen smoothly and Alternative Reference Rate Committee (ARRC), the working group under Federal Reserve will help in this regard.
LIBOR is calculated over seven different tenors, across five different currencies, it is used in loans, bonds, markets, derivatives and thus is a global benchmark reference rate. LIBOR is an indicator of liquidity when the market is volatile, it is forward looking in nature. The new RFR should be able to produce forward-looking interest periods giving the market a sense of certainty where one knows the interest rate for an interest period at the beginning of an interest period. RFRs becoming more predictable to financial institutions will become the key to indicate liquidity in RFR markets. As more institutions use RFRs, their liquidity will grow leading to diminished LIBOR liquidity, just like a see-saw. RFRs are based on real transactions and use references from actual overnight trade data making it more robust and risk free. And that is why RFRs are priced without a credit risk premium like in the case of LIBOR.
Since it is now confirmed that the days with LIBOR is numbered, any delay in transition from LIBOR will lead to a hefty loss. The market should adopt the RFR compounded in arrears approach instead of waiting for a true term RFR. This approach should be the new norm in bilateral and syndicated loan markets. The importance of liquidity in RFRs by using SONIA and SOFR and the stability it offers in term rates, gives hope to financial institutions to produce more term rates. We can thus conclude that the transition from LIBOR to RFR will not be as risky and volatile since RFRs provides the necessary stability to liquidity in market rates.