The LIBOR Transition

For decades, LIBOR — the London Interbank Offered Rate — underpinned trillions of dollars of loans, swaps, and mortgages, set daily from a panel of banks each estimating what it would cost them to borrow unsecured from another bank. That design had two problems: by the 2010s the underlying unsecured interbank lending market had largely dried up, so banks were often estimating a rate for transactions that barely happened, and several panel banks were caught submitting rates to benefit their own derivatives positions rather than reflecting genuine borrowing costs. Regulators responded by pushing the market to replace LIBOR with benchmarks built from actual, observable transactions — in the US, SOFR, derived from real overnight Treasury repo trades, rather than from any bank's opinion.

The transition, largely completed by mid-2023, required rewriting or adding "fallback" language to an enormous stock of existing contracts, and because SOFR is a secured overnight rate while LIBOR embedded unsecured term-lending and bank-credit risk, contracts needed a spread adjustment added on top of SOFR to approximate what LIBOR would have paid, avoiding a windfall or loss to either side of a contract purely from the benchmark switch. Markets also had to build new derivatives — like Term SOFR, a forward-looking rate constructed from SOFR futures rather than a panel estimate — for the many contracts and loan facilities that had relied on knowing a rate in advance rather than only overnight, and that in turn had to be reconciled against the daily-compounded SOFR conventions used in most swaps.