SOFR vs LIBOR: Preparing for the Transition With AI

Since 1986, the London Interbank Offered Rate (LIBOR) has been the interest rate standard for global banks making short-term loans to one another. LIBOR is often referenced in derivative, bond, and loan documentation—including mortgages and student loans. This long-standing international benchmark, scheduled to end after 2021, will be replaced by the Secured Overnight Financing Rate (SOFR).

As a result, a mass of contracts will need to be renegotiated within the coming year. Unfortunately, the switch cannot be accomplished by simply revising a few terms or figures in the contracts; instead, the transition requires a deep understanding of the mechanisms that inform the SOFR vs LIBOR rules. 

A contract negotiation platform powered by artificial intelligence (AI) may provide the answer for in-house corporate legal teams navigating the LIBOR transition and faced with the task of having to modify all of their existing LIBOR agreements.

SOFR vs. LIBOR: Why the Transition Is Far From Simple

Several issues arise when making the switch from LIBOR to SOFR:

• Existing fall-back provisions were not meant to cover long-standing gaps. Contracts cannot be left to their temporary fall-back provisions, as a vast number of price changes would cause disruptive effects across financial, operational, and customer service channels.
  
  
• Customer ignorance would cause confusion and potential reputational damage. Financial institutions may find counterparties unwilling to agree to new terms. Most variable-rate mortgage customers do not understand how LIBOR or SOFR work, so financial firms may encounter difficulty explaining why, for instance, SOFR’s proposed rate of +230 is a better deal than their LIBOR rate of +200 points.  
  
  
• SOFR’s Risk-Free Rates (RFRs) do not take into account perceived credit risk. SOFR is preferred to LIBOR because it takes a historical view of actual transactions rather than hypothesizing a forward-looking estimate. Unfortunately, this also means that SOFR does not include the price of bank credit risk, which could produce unintended “winners” and “losers” with its volatility. The overnight repo rates of U.S. government treasuries used in SOFR can be somewhat unstable, though new benchmarks have proven helpful in some circumstances. Institutions will have to decide upon a strategic approach—either hardwired (using a waterfall of potential replacement rates like term SOFR, compounded SOFR, or another negotiated alternative), or amendment-based (using spread adjustments and a triggered, negotiated replacement rate).

AI Tools Can Analyze LIBOR-Based Contracts at Scale

Artificial intelligence software has advanced significantly within the last few years. Many firms and banks are adopting AI tools to digitize, analyze, and even renegotiate LIBOR-based contracts. A cloud-based contract negotiation powered by AI can be used to:

• Digitize, sort, and analyze the agreements that need amending.

• Flag ambiguous, dated, or LIBOR-based amendments that require attention.

• Omit old fall-back provisions that are no longer necessary and update with robust terms.

• Propose best-practice language based on SOFR for the highlighted clauses.

• Make all changes automatically if approved by the parties.

Next-generation AI tools that aggregate your legal departments’s contract guidelines and controls into an AI Digital Playbook can successfully update LIBOR and SOFR-based contracts with guidance from the Alternative Reference Rates Committee (ARRC) and the International Swaps and Derivatives Association (ISDA). Routine contract review tasks—like flagging and redlining—can be accomplished by the AI in minutes. The same tasks would require hours, or even days, for an attorney to complete. 

Additional advances in machine learning have enabled the most sophisticated AI tools to insert playbook-compliant language directly into the contract during the review and negotiation process. Suggested revisions are based on successful past negotiations and business best practices. Whether your department is navigating the LIBOR vs SOFR transition or updating other regulatory or in-house contract standards, an AI-powered contract management platform can enable your legal team to accelerate the contract review and negotiation process while ensuring all of your negotiations meet current regulatory requirements.