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Analysis

The Derivatives Market ‘X Factor’

Addressing the big unknowns in the transition from LIBOR to SOFR.

By David Munves | February 24, 2022 at 03:54 PM
Stock illustration: Nailing down an interest rate

Much ink has been spilled over the sunsetting of the London interbank offered rate (LIBOR) and its replacement (in U.S. dollars) by the Secured Overnight Funding Rate (SOFR). The SOFR benchmark rate measures the cost to banks of borrowing cash overnight on a collateralized basis. To date, the commentary has mostly focused on the enormous sums involved—the $223 trillion in LIBOR instruments outstanding—and the behaviors uncovered in the 2013 LIBOR scandals that led regulators to decree that LIBOR had to be replaced by a new benchmark.

Less attention has been paid to the question of how trading in SOFR instruments will evolve over time. Yet this is what really matters. Trading is where money will be made and lost in the new market—it’s where the rubber hits the road. In time, SOFR will become an effective replacement benchmark for LIBOR. However, the current lack of a developed SOFR derivatives market will have many unforeseen, and adverse, impacts on both financial market participants and businesses and consumers exposed to LIBOR-based products.

 

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