SOFR and LIBOR as Indicators of Credit Risk
Summary
The document compares SOFR and three-month LIBOR as indicators of credit risk. SOFR is based on secured overnight borrowing, while LIBOR included unsecured bank credit and term liquidity premia. Futures on both rates offer exposure to expected future rates, but the underlying benchmarks can respond differently to financial stress. Collateral supply conditions can also affect SOFR.
The discussion points to March 2020 as an example: flight to quality and Federal Reserve liquidity pushed SOFR lower while banking credit concerns pushed three-month LIBOR higher. SOFR draws on a large volume of transactions and is described as harder to manipulate, but its secured overnight design makes it a different measure of bank credit conditions. The document mentions credit-sensitive alternatives, while noting that one named benchmark was scheduled for discontinuation in 2024. It provides qualitative comparison rather than a quantitative test of indicator performance.
Key ideas
- SOFR measures secured overnight funding, whereas LIBOR included unsecured credit and term premia.
- Futures provide exposure to future rates but do not make the benchmarks equivalent measures of credit risk.
- Collateral scarcity or abundance can influence SOFR.
- The March 2020 example illustrates that the rates can diverge during market stress.
- Transaction volume is cited as an advantage for SOFR in reducing manipulation concerns.
Tags
Full text
# TED Spread Replacement? # TED Spread Replacement? Will replacing the 3-month tenor of the US LIBOR with SOFR or CME 3-Month SOFR Futures work as well as an indicator of credit risk? I have my doubts given: - SOFR reflects secured lending - LIBOR is forward looking - LIBOR incorporates term liquidity and credit premia ## Answer by JoshK (score 3, accepted) https://quant.stackexchange.com/a/50516 I think it's a good question. But just remember a few nuances: - They both do have futures, so you can get exposure to future rates. For example, you can trade June Eurodollars now as well as June SOFR futures. - They both do have credit risk. Just less with SOFR since it is collateralized. - Another nuance. Sometimes there are collateral scarcities or over-saturation of collateral. That will give SOFR some characteristics that are not present in LIBOR. But your fundamental point is right - SOFR is a bad replacement for LIBOR. ## Answer by dm63 (score 3) https://quant.stackexchange.com/a/50515 You are correct. SOFR is an overnight, secured lending rate. It does not have an unsecured credit risk element , and it does not have a term premium. As a result, it is expected to behave differently to 3month libor in a credit crisis. However it has advantages: it is based on a large volume of transactions and is therefore much harder to manipulate than Libor, for example. ## Answer by AKdemy (score 2) https://quant.stackexchange.com/a/63764 There is a number of companies who seek to develop and offer a credit sensitive benchmark. - ICE's Bank Yield Index - Bloomberg's BSBY Index So if you desire an indicator for (perceived) credit risk, these will be the go to indices. Why this is needed (or there is a desire for such indices) becomes clear when looking at March 2020. Flight to quality and FED liquidity pushed SOFR down, but credit concerns in banking pushed up 3m Libor. Edit BSBY will be discontinued on November 15,2024 after a damning Iosco verdict, see Risk.net.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.