Alternative reference rates: Meaning, Criticisms & Real-World Uses

What Are Alternative Reference Rates?

Alternative reference rates (ARRs) are interest rate benchmarks designed to replace the London Interbank Offered Rate (LIBOR) and other interbank offered rates (IBORs) that have faced scrutiny. These new financial benchmarks aim to be more robust and reliable, typically based on actual market transaction data from highly liquid overnight wholesale money market transactions, rather than expert judgment or surveyed submissions. The shift to alternative reference rates is a significant development in financial markets, impacting a vast array of financial contracts globally. This transition falls under the broader category of market infrastructure and regulatory reform within financial economics.

History and Origin

The origins of alternative reference rates are deeply rooted in the need to reform global financial benchmarks following the manipulation scandals involving LIBOR. Concerns about the integrity and reliability of LIBOR, particularly its susceptibility to manipulation and declining liquidity in the underlying unsecured interbank lending markets, led global regulatory bodies to push for its cessation. The Financial Stability Board (FSB), an international body that monitors and makes recommendations about the global financial system, played a crucial role in coordinating international efforts to identify and transition to new, more robust benchmarks.¹⁰,

In response to these concerns, various national working groups were established by central banks and regulatory authorities. For instance, in the United States, the Alternative Reference Rates Committee (ARRC) was convened by the Federal Reserve Board and the New York Fed in 2014 to identify and facilitate the transition to a new U.S. dollar reference rate.⁹ This committee ultimately recommended the secured overnight financing rate (SOFR) as the preferred alternative. Similarly, the Bank of England reformed the sterling overnight index average (SONIA) to serve as the primary sterling risk-free rate, enhancing its methodology based on a broader scope of overnight unsecured deposits.⁸,⁷ The European Central Bank (ECB) developed the euro short-term rate (€STR), which began publication in October 2019, reflecting wholesale euro unsecured overnight borrowing costs., ⁶T⁵hese coordinated global efforts marked a significant shift away from benchmarks reliant on submissions toward those based on actual transactions.

Key Takeaways

Alternative reference rates are transaction-based benchmarks designed to replace interbank offered rates like LIBOR.
They aim to be more robust, transparent, and less susceptible to manipulation than their predecessors.
Key alternative reference rates include SOFR (USD), SONIA (GBP), and €STR (EUR).
The transition to alternative reference rates impacts a wide range of financial products, including loans, bonds, and derivatives.
The shift reduces systemic risk by anchoring financial instruments to more reliable market data.

Interpreting Alternative Reference Rates

Interpreting alternative reference rates involves understanding their underlying methodologies, which typically focus on observable market transactions. Unlike LIBOR, which incorporated an element of bank credit risk, many alternative reference rates are considered "nearly risk-free" rates. For instance, SOFR is based on actual transactions in the U.S. Treasury repurchase agreement market, reflecting the cost of overnight borrowing collateralized by U.S. Treasury securities.

Similarly, SONIA reflects the average of interest rates paid on sterling short-term wholesale funds, while €STR represents unsecured overnight borrowing costs in the euro area., The ⁴i³nterpretation of these rates primarily involves observing the pure cost of overnight funding, with minimal or no embedded bank credit risk. Users of alternative reference rates must therefore consider how credit risk premiums, if necessary, are added on top of these base rates to accurately price financial products and manage exposure.

Hypothetical Example

Consider a company, "DiversiCo," that needs to take out a new corporate loan. Historically, this loan might have been tied to LIBOR. With the transition to alternative reference rates, DiversiCo's new $10 million, 5-year variable-interest rate loan is now linked to SOFR plus a spread.

Let's say the agreed spread is 150 basis points (1.50%). If the daily SOFR published by the Federal Reserve Bank of New York is 5.25%, then the interest rate for that period would be calculated as:

\text{Interest Rate} = \text{SOFR} + \text{Spread} \\ \text{Interest Rate} = 5.25\% + 1.50\% = 6.75\%

This means DiversiCo would pay interest based on an annual rate of 6.75% for that day's accrual period. The actual interest payment calculation for the full period would involve compounding the daily SOFR rate over the interest period, then adding the spread. This mechanism ensures that the loan's interest payments accurately reflect prevailing overnight funding costs.

Practical Applications

Alternative reference rates are fundamental to the pricing and valuation of numerous financial products across global markets. Their applications span various segments:

Loans: Corporate loans, syndicated loans, and consumer loans (e.g., mortgages, student loans) are increasingly being originated with alternative reference rates as their underlying benchmark. This transition ensures that the interest rates on these loans are reflective of robust, transaction-based market activity.
Bonds: The issuance of floating-rate notes (FRNs) referencing alternative reference rates has become standard practice. These bonds pay interest that adjusts periodically based on the prevailing ARR, providing investors with variable income tied to market conditions.
Derivatives: A vast majority of over-the-counter (OTC) and cleared derivatives, such as interest rate swaps and futures, have migrated from LIBOR to alternative reference rates. This includes SOFR futures and options, SONIA swaps, and €STR-linked instruments, facilitating hedging and risk management based on the new benchmarks. The Alternative Reference Rates Committee (ARRC) provides extensive resources and guidance on this transition, highlighting the shift across various products.
S²ecuritized Products: Products like collateralized loan obligations (CLOs) and residential mortgage-backed securities (RMBS) that traditionally relied on LIBOR are now linked to alternative reference rates, ensuring their underlying cash flows are calculated based on the new, more resilient benchmarks.

Limitations and Criticisms

While alternative reference rates offer significant advantages in terms of robustness and transparency, they are not without limitations or criticisms. One common point of discussion is the "term rate" challenge. Many ARRs, such as SOFR, SONIA, and €STR, are overnight rates, reflecting the cost of borrowing for a single day., This con¹trasts with LIBOR, which offered rates for various maturities (e.g., one-month, three-month, six-month LIBOR). Market participants, particularly in loan markets, often prefer a forward-looking term rate for budgeting and operational ease. While term versions of ARRs (e.g., Term SOFR) have been developed, their liquidity and usage scope are still evolving compared to the broad acceptance LIBOR once enjoyed for various tenors.

Another consideration is the absence of a built-in bank credit risk component in many ARRs. LIBOR reflected unsecured interbank lending, thereby incorporating a premium for bank credit risk. Since ARRs like SOFR are nearly risk-free, parties engaged in transactions requiring a credit-sensitive rate must add a credit spread on top of the ARR. This requires careful calibration and may introduce complexity in pricing and hedging. Challenges can also arise in legacy contracts that lacked robust fallback language for the transition, potentially leading to legal and operational hurdles. Despite these points, global regulatory bodies continue to advocate for the widespread adoption of alternative reference rates due to their fundamental improvements in reliability.

Alternative Reference Rates vs. LIBOR

The primary difference between alternative reference rates and LIBOR lies in their underlying methodology and the type of risk they reflect.

Feature	Alternative Reference Rates (e.g., SOFR, SONIA, €STR)	LIBOR (London Interbank Offered Rate)
Calculation Basis	Predominantly based on actual, observable transactions in wholesale markets.	Based on surveyed submissions from a panel of banks, reflecting their estimated borrowing costs.
Risk Profile	Nearly risk-free (e.g., SOFR based on secured transactions) or reflect minimal credit risk (e.g., €STR reflects unsecured but broad market).	Incorporated an element of bank credit risk, as it was an unsecured interbank lending rate.
Transparency	High, as they are derived from liquid and observable market activity.	Lower, due to reliance on expert judgment and potential for manipulation.
Tenors	Primarily overnight rates, with term rates typically derived from derivatives markets.	Published for various forward-looking tenors (e.g., 1-month, 3-month, 6-month).
Administration	Administered by central banks (e.g., Federal Reserve Bank of New York for SOFR, Bank of England for SONIA, ECB for €STR).	Administered by ICE Benchmark Administration (IBA), based on bank submissions.

The confusion often arises because both served as key benchmarks for setting interest rates in financial instruments. However, the fundamental shift in their calculation basis and risk profile has necessitated a comprehensive global transition away from LIBOR to alternative reference rates to enhance financial stability and market integrity.

FAQs

Why were alternative reference rates introduced?

Alternative reference rates were introduced primarily to replace the London Interbank Offered Rate (LIBOR) due to concerns about its reliability and susceptibility to manipulation. Regulators sought more robust benchmarks based on actual, observable transaction data.

What are the main alternative reference rates?

The main alternative reference rates include the Secured Overnight Financing Rate (SOFR) for the U.S. dollar, the Sterling Overnight Index Average (SONIA) for the British pound, and the Euro Short-Term Rate (€STR) for the euro. Other jurisdictions have also adopted their own respective ARRs.

How do alternative reference rates differ from LIBOR in terms of credit risk?

Most alternative reference rates, particularly SOFR, are considered "nearly risk-free rate" as they reflect the cost of secured overnight borrowing or very low-risk unsecured borrowing. In contrast, LIBOR historically included an element of bank credit risk, as it was based on unsecured interbank lending. This difference means that for some financial products, a credit spread may need to be added to the ARR to account for the credit risk of the borrower.