Introduction

LIBOR has been met with controversy and declining popularity since the 2008 financial crisis. Critics postulate that calculation mechanism allows lenders to manipulate LIBOR. In response, regulators have worked to find alternatives which they believe will address the drawbacks of LIBOR. Such efforts have culminated in LIBOR is being phased out in favour of SOFR (Secured Overnight Financing Rate).

SOFR is the official recommendation of the Alternative Reference Rates Committee (ARRC). ICE Benchmark Administration (IBA) has stopped publishing all non-USD LIBOR rates and some USD LIBOR rates since 31st December 2021. LIBOR is to be completely phased out by June 30th 2023 in favour of SOFR and similar alternatives.

LIBOR vs SOFR 

SOFR is the cost of borrowing cash overnight collateralized by U.S Treasury securities in the repo market. While LIBOR is calculated based on submissions presented by participating banks, SOFR is calculated based on transaction-level data collected by the US Federal Reserve and DTCC Solutions LLC (an affiliate of the Depository Trust & Clearing Corporation). The transactions utilized for the calculation of SOFR are greater in volume than those under LIBOR. Proponents say that this will allow for more accuracy, transparency and reliability of the rate.

SOFR is published by the Federal Reserve Bank of New York (New York Fed) after it has been calculated based on transactions of the previous US Government Securities Business Day. The overnight rate is published at 8:00 am ET. If there is a revision to be made to account for mistakes and/or missing data, the rate will be subsequently updated at 2:30 pm ET. 

LIBOR is forward-looking and prospective, with the interest rate calculated using bank estimates. SOFR is backward-looking, with the interest rate being calculated based on actual transactions that have taken place. Term SOFR, which is most similar to LIBOR is however forward looking. Term SOFR is however not very common in Europe and Asia. Other types of SOFR (such as the Daily Simple SOFR and Daily Compounded SOFR) dominate these markets. Daily SOFR is calculated using a simple overnight interest rate while Daily Compounded SOFR is calculated by compounding overnight SOFR rates daily. SOFR is also more volatile than LIBOR, especially Daily Simple SOFR.

Commentary

Local banks and foreign banks operating from within the Maldives predominantly lend on a fixed rate basis. This change therefore may not have an impact on such transactions. However, we anticipate growth in the use of variable interest rates by local lenders over the next few years. 

Where parties have agreed for variable rates, it is advisable for both lenders and borrowers to amend agreements with fallback language to account for changes in the benchmark reference rate. The language should draft such that it triggers in situations where the existing reference rate is unavailable. With the incorporation of fallback language, there will be no need for subsequent amendments in situations where the interest benchmark rate settings are unavailable. 

Lenders and borrowers are well advised to consider standard draft language for various products published by the London Market Association.

With the proper impact advice and a well-thought-out strategy, parties can smoothly transition from LIBOR-based financial products to SOFR-based ones, without attracting liability or unnecessary exposure to risk.