Dreyfus Reviews LIBOR to SOFR
Dreyfus Cash Investment Strategies published, "LIBOR to SOFR: The Impact on Money Market Funds," which tells us, "The London Interbank Offered Rate (LIBOR) -- the most commonly used reference interest rate in the financial world -- is scheduled to be replaced by the Secured Overnight Financing Rate (SOFR) at the end of 2021. Some floating rate money market securities have interest rates that are linked to LIBOR, and investors have been concerned about the potential impact of this change on money market funds." They explain, "The challenges of replacing LIBOR in the money market are less daunting than in other credit markets. Short-term, LIBOR-based securities purchased by money market funds will have largely matured, or reached their final reset, by the yearend 2021 deadline, eliminating many of the difficulties inherent in the transition. Short-term, SOFR-based securities have already been issued by government agencies and are increasingly being issued by banks, supranational organizations, and insurance companies." Dreyfus explains, "Two challenges have yet to be fully resolved. First, while LIBOR rates include a term structure of seven maturities, ranging from overnight to one year, SOFR is strictly an overnight rate. So, a SOFR term structure will need to be implemented. Second, because LIBOR is based on unsecured transactions, it reflects the credit risk of the borrower. In contrast, SOFR is secured by US Treasuries, so this rate does not incorporate a credit risk component." They add, "These two issues are being addressed by industry groups, and a number of solutions are being considered. The term structure challenge could be resolved by the development of a SOFR futures market. SOFR futures have been traded on the Chicago Mercantile Exchange since 2018, so this may offer a realistic solution. As for the credit-risk component, the New York Federal Reserve has created the Credit Sensitivity Group to examine this issue. Currently, market participants build in a credit element themselves, adjusting the spread at which they choose to purchase SOFR-based securities. Using another index as an alternative to LIBOR could also resolve these two challenges. Two possible alternatives are Ameribor and the ICE Bank Yield Index. Unlike LIBOR, they are entirely transaction-based. However, similar to LIBOR, they include a term structure. In addition, because they are based on unsecured transactions, they also reflect credit risk." Finally, the brief adds, "The year-end 2021 deadline may have to be extended if the financial industry fails to fully prepare for the SOFR transition, but BNY Mellon is assuming the current deadline will stand. We will continue to monitor progress on the remaining challenges and to advocate for suitable solutions. In this paper, we will outline the issues, summarize what has been done to address them, and discuss solutions that are still being considered."
