I. LIBOR Interest Rate
The London Interbank Offered Rate ("LIBOR") is an interest rate that has been used by investors and banks in loan agreements since the 1980s. This rate is published by the ICE Benchmark Administration ("IBA"). LIBOR is determined by calculating the average interest rate used in contracts between major banks and financial institutions.
In the past, the LIBOR interest rate was set for the US Dollar, Euro, British Pound, Japanese Yen and Swiss Franc. However, as of 2021, LIBOR interest was determined only for the US Dollar.
LIBOR interest rate was previously set for overnight, one-month, two-month, three-month, six-month and twelve-month maturities. However, as of 2021, one-week and two-month LIBOR rates were no longer set.
The LIBOR interest rate is essentially based on the forward-looking forecasts of major banks and financial institutions. This creates a situation that is open to manipulation. In 2012, it became clear that some banks and financial institutions were abusing this situation to increase their profits. Therefore, the LIBOR interest rate system was gradually abandoned.
II. Substitution of the SOFR Interest Rate for the LIBOR Interest Rate
Some banks and financial institutions were unfortunately abusing their influence over the setting of the LIBOR interest rate in order to increase their profits. Therefore, the Federal Reserve System ("FED") formed a committee to establish a new interest rate standard. As a result, a new interest rate standard, the Secured Overnight Financing Rate ("SOFR"), was established.
In 2012, the FED and the UK authorities agreed to phase out the LIBOR interest rate. As a result, they decided to phase out the LIBOR interest rate completely as of June 30, 2023.
Currently, many older contracts have been based on LIBOR interest rate. These contracts can be automatically converted to bear SOFR interest rate through the operation of fallback clauses in the contractual text. If the contract does not contain such fallback provisions, the parties may amend the contract to eliminate the LIBOR interest rate and adopt the SOFR interest rate.
Pursuant to a law enacted in the State of New York, the relevant provision in contracts based on LIBOR interest rate will be automatically modified and SOFR interest rate will be deemed to be accepted instead of LIBOR interest rate. Pursuant to the said law, it is also possible for the parties to determine an alternative interest rate other than SOFR interest rate.
III. Features of SOFR Interest Rate
SOFR is a type of interest rate set for use on contracts denominated in US dollars. The FED announces SOFR interest rates every business day.
SOFR is a volume-weighted calculation of data obtained from realized transactions. Therefore, a more objective method is used compared to the LIBOR interest rate.
As mentioned above, unlike LIBOR, SOFR is calculated on the basis of past transactions, not future forecasts. Therefore, the borrower will only know the amount of interest to be paid when it is due. Although this has led to the SOFR interest rate system being considered more reliable than the LIBOR interest rate system, it is a practice that poses still problems in terms of predictability.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
