LIBOR to SOFR: How Will the Transition Impact Supply Chain Finance?
By 4 minute read• Published July 30, 2020 •
In the last few months, I’ve had several conversations with customers and bank executives about LIBOR. These discussions have largely focused on the following questions: Is SOFR still replacing LIBOR? If so, how will the transition impact supply chain finance funding costs?
Before we answer those questions, we need to revisit what’s happening with LIBOR. In short, LIBOR (London Inter-bank Offered Rate) is an interest rate average calculated daily from estimates submitted by the leading banks in London. It effectively sets the rate at which banks can lend to one another and serves as the benchmark rate for loans across the world worth trillions of dollars.
LIBOR drew scrutiny during the global financial crisis, when financial institutions manipulated it to boost returns and hide financial weakness. This precipitated global calls for a replacement. Thus, a timeline was set for LIBOR to phase out sometime early 2022. The leading contender to replace LIBOR is the Secured Overnight Financing Rate (SOFR), which is published by the New York Federal Reserve.
Today, the financial industry is staring down a rapidly approaching deadline that is ill-timed given current economic volatility. With this in mind, many finance executives are curious about what will (or will not) happen to LIBOR in the coming months, and how it will affect their business.
Is LIBOR still going away?
Currently, there are no indicators that the Federal Reserve has plans to push the early 2022 timeframe. Recent comments from Federal Reserve Bank of New York President John Williams suggest SOFR has fared well despite stresses seen in the financial system during the coronavirus pandemic.
Regardless, there is a groundswell among financial experts to reconsider both timing and approach. Much of the debate about LIBOR has fizzled out. It’s also difficult to predict when the global economy will recover and what recovery will look like. If the U.S. economy is in a recession at the end of 2020, it’s reasonable to expect the Federal Reserve will focus its efforts on the economy and the timing for replacement will be pushed further into the future.
How will a move from LIBOR to SOFR impact supply chain finance funding costs?
We believe the implementation of SOFR will actually lower base rates – not significantly, but lower nonetheless. LIBOR incorporates a built-in credit risk analysis component because it represents the average cost of borrowing by a bank. In contrast, SOFR does not include a credit risk analysis component and represents a “risk-free” rate (because it’s based on Treasury rates), which will ultimately work in the favor of a lower base rate.
How will this change filter through PrimeRevenue’s supply chain finance platform?
In all likelihood, a move to SOFR will not impact PrimeRevenue customers. However, there are two variables to consider. First, banks must choose to use SOFR as their base rate calculation model as there is no mandate on which rate they are required to use. Fortunately, there is already growing consensus around SOFR with several large banks already testing it out on their own systems to ensure compatibility.
Second, banks have a choice between two different SOFR models – simple interest SOFR or compound interest SOFR. Simple interest SOFR most closely resembles the LIBOR calculation model, and most systems that use LIBOR will be able to seamlessly transition to SOFR (including PrimeRevenue’s platform). The compound interest SOFR model will require banks to make widespread technology modifications. Our conversations with financial institutions thus far suggest most banks don’t want to take on the headache and cost of compound interest SOFR and will opt for the simple interest model instead.
We’ll continue to keep a close eye on what’s happening with LIBOR. Nevertheless, PrimeRevenue will support our clients through whatever the future holds. Stay tuned for updates.