The British Bankers Association introduced LIBOR (London Interbank Offered Rate) in 1986. Over time, this index became the dominant variable rate benchmark index for derivatives and financial instruments, which include mortgages.
Currently, there are more than $350 trillion LIBOR-indexed products outstanding globally. The index was originally designed for the panel reference banks as a borrowing rate between each other, in the London interbank market. The rate is determined each day by collecting rates from these 18 reference banks. They discard the highest and lowest four rates. Then, the average of the remaining submission is the current day LIBOR rate. The rate is not based on actual transactions, making it subject to potential manipulation by the panel reference banks.
After years of trying to tie LIBOR to transactions rather than judgment, the United Kingdom’s Financial Conduct Authority announced in July 2017 they would no longer compel reference banks to submit LIBOR.
In 2014, the Intercontinental Exchange took over administration of LIBOR and the Federal Reserve established Alternative Reference Rates Committee (ARRC) to assess viable alternatives. They identified SOFR (Secured Overnight Financing Rate) as the successor to LIBOR. SOFR is a measure of the cost of borrowing on an overnight basis in the U.S. Treasury repurchase agreement (repo) market and is based entirely on observable transactions in the market.
There is more work to be done to use SOFR as a replacement for LIBOR. For example, SOFR is currently only an overnight rate and it needs to be developed into a term rate to be more comparable to LIBOR. The existing markets rely on term periods (1-month and 3-month) so market participants are hopeful that introduction of futures can assist in developing SOFR into a useful index. A hypothetical history was created going back five years which should make this index more reliable moving forward. SOFR remains volatile at month-, quarter- and year-end, so the work continues to develop this index.
For a quick reference, the chart below depicts the difference in these two indices.