The Path to SOFR and Alternatives
Is LIBOR Replacement Really One Size Fits All?
The choice of SOFR, the Secured Overnight Financing Rate, to replace LIBOR has been controversial from the start. The notion of replacing an unsecured, forward looking term rate with a daily, secured and backwards looking index has left sophisticated market participants scratching their heads. As SOFR fundamentally resets off a compilation of Repo transactions, the mid-September Repo hiccup which sent funding levels for Treasury collateral soaring toward 10% has exacerbated the discussion around the merits of the proposed replacement for the $200 trillion LIBOR market. In early 2019, ICE Benchmark Administration, a leading provider of global interest rate and other financial benchmarks, introduced the U.S. Dollar ICE Bank Yield Index for review. The index is designed to measure yields investors are willing to invest U.S. dollar funds in large internationally active banks on a wholesale, unsecured basis over similar forward-looking tenors like LIBOR.
Brief History: What is the Secured Overnight Financing Rate (SOFR)
In mid-2017, the Alternative Reference Rates Committee (ARRC) endorsed SOFR (Secured Overnight Financing Rate), as the preferred rate to replace LIBOR. SOFR is now being published daily by the Federal Reserve Bank. SOFR is intended to be a broad and directly observable measure of the cost to borrow cash overnight and collateralized by Treasury securities through repurchase agreements. The general collateral repo (GC) repo market is what keeps the US government securities market functioning daily. In choosing SOFR as the preferred choice to replace LIBOR, the regulators were seeking an index that was fully transaction based, included a robust underlying market covering broader segments of the repo market (Tri-party + cleared FICC bilateral repo) and a rate that correlated with other money market indexes (EFF, Overnight Bank Funding Rate, IOER and Tri-Party GC). LIBOR currently references some $200 trillion worth of financial contracts across Derivatives, Loans, Securities, Mortgages and Business and Consumer Loans.
How Did We Get Here? The Wheatley Review of LIBOR (September 2012)
Coming out of the Global Financial Crisis, and since 2009, the Financial Services Authority (FSA) in conjunction with other global regulators from the United States, Japan, Canada and European Union began investigations around misconduct with numerous global benchmark rates, LIBOR included.
In June of 2012, Martin Wheatley, MD of the FSA and CEO of the Financial Conduct Authority was tasked with conducting an independent review of the rate setting process of LIBOR and its subsequent use. A few findings from the report:
1) Clear case of comprehensive “reform” not replacement.
2) Transition to a new benchmark would pose unacceptably high risk of financial instability.
3) Transaction data should be used to explicitly support LIBOR submissions.
4) It would not be appropriate for the authorities to completely take over process for producing a new benchmark.
5) The BBA should transfer responsibility for LIBOR to a new administrator.
Some other key dates:
1) In July of 2014, the Official Sector Steering Committee (OSSG) tasked with overseeing market reforms, concluded LIBOR would need to be replaced by multiple reference rates including a risk-free rate for derivative contracts, as well as a rate that references bank credit for banks to hedge their funding costs.
2) On February 1, 2014, the Intercontinental Benchmark Administration (IBA) took over the administration of LIBOR, now called ICE LIBOR.
3) In 2014, The Federal Reserve Board and the New York Fed tasked the private group Alternative Reference Rate Committee (ARRC) to identify risk-free alternative reference rates considering several forms of unsecured bank borrowing (CP, CDs, Eurodollar) as the basis for a new rate.
4) The ARRC (2016) ultimately dismissed the unsecured rates because of “structural difficulties”: limited transactions, not robust enough and unstable bank participation.
5) On June 22, 2017, the ARRC identified SOFR as its recommended alternative to USD LIBOR.
Why Was SOFR Chosen?
The evolution of the global financial crisis lent itself to many questions over the rate setting nature of LIBOR and manipulation. In a nutshell, inappropriate behavior in some cases was revealed, exposed and addressed. Bad behavior can be found in any business. And when addressed, choices must be made with regards to the best course of action. In the case of LIBOR, instead of reforming the process around the rate setting process while maintaining “LIBOR” as the continued index across trillions of contracts, the regulators made the decision to throw the baby out with the bath oil. In the end, the human element was to be replaced with observable, “transaction based” volumes daily. And in the days after the dust settled coming out of the GFC, and LIBOR volumes shrinking as a percentage of the overall derivative market, Repo stood out as a very robust, voluminous product with stable, observable and predictable daily rates.
Is SOFR Short-Sighted?
It is understandable why the regulators would want to take the human risk factor out of LIBOR coming out of the GFC. Yet, the choice of replacement and more important replication of the market “characteristics’ very much matters for many end users globally. This applies to both existing and future exposure. From a hedging, portfolio and risk management perspective the value of LIBOR based interest rate and volatility products is undeniable over time. And if you look at how LIBOR Swap Spreads behaved during the market turbulence of 2007-2008, they served as a reliable hedge in many cases versus other underlying cash products. In reality, and the more conversations with end users that occur, SOFR is simply not viewed in the same light. In many cases, quite the opposite in market behavior in times of market turbulence.
Tale of the Tape: LIBOR vs SOFR
We thought it would be helpful to include a quick snapshot on the differences between existing LIBOR and SOFR. While we acknowledge the importance of observable, voluminous traits of the underlying in composing an index, the characteristics of market behavior as a hedging, portfolio and risk management tool are of equal, if not more importance, for the end-user. In choosing SOFR as a LIBOR replacement, the regulators gave significant consideration toward control of the “rate setting” dynamic, and very little thought toward the end-user and practical implications for market behavior over time between secured and unsecured instruments.
Unsecured Rate Secured Rate
Forward Looking Tenors Backward looking
Credit Component Minimal Credit Risk
Is the Move from LIBOR One Size Fits All?
Depends Who You Speak With…
It is hard to believe the conversion of a market worth over $200 trillion in value across derivatives, cash and loans can be accomplished with simply one, seamless replacement. Yet, to a large extent this is the way the US regulators are approaching the move away from LIBOR.
1) The Fed
In a recent speech on October 17th, 2019 New York Fed President Williams ended by addressing SOFR with consideration toward the recent hiccup in the Repo market.
Let’s take a look:
Williams: What Does All of This Mean for SOFR?
But before I close, I’d like to emphasize an important point about a particularly important repo benchmark rate, and that’s the Secured Overnight Financing Rate, or SOFR. SOFR is the reference rate that the Alternative Reference Rates Committee (ARRC) has selected as the preferred replacement for LIBOR”
“While we saw turmoil in the repo market, we saw a temporary spike in SOFR. As market participants prepare to transition away from LIBOR, they’re understandably watching SOFR very closely”
“There are a few things I’d like to highlight with respect to SOFR. First, a temporary spike is not surprising, given that SOFR reflects rates on real-world transactions. Second, the very fact that we saw a spike in SOFR is an indication of how representative of its underlying market it is. It’s based on actual transactions, rather than judgment (like LIBOR), which is part of what makes SOFR so robust. Third and final, is that in the vast majority of use cases, the relevant metric for SOFR is an average over time. Focusing on overnight SOFR isn’t particularly useful in this context, as financial contracts will generally refer to an average of SOFR over many weeks or months”
My (Williams) message to you is: “Don’t let last month’s temporary spike in SOFR or hope for the creation of some other replacement reference rate, become an excuse for delaying your transition away from LIBOR. I’ve said it before and I’ll say it again: like death and taxes, the end of LIBOR is unavoidable, and we must do all that it takes to prepare for a LIBOR-less future”
2) The Bank for International Settlements (BIS)
In March of 2019, the Bank for International Settlements (BIS) commented on benchmark conversion with terms rates that include a credit component:
“Against this background, authorities in jurisdictions where it was deemed feasible to reform credit-sensitive term benchmarks similar to LIBOR have opted for a “two benchmark” approach (as advocated by Duffie and Stein (2015)). This combines a benchmark based on O/N RFRs with another based on reformed term rates which embed a credit risk component, which would be more suitable for banks’ asset liability management”
From the BIS “Beyond LIBOR” a primer on the new reference rates, March 2019
3) In 2015, from the Journal of Economic Perspectives, distinguished global economists Darrell Duffie and Jeremy C. Stein on the impending move from LIBOR and referenced by the 2019 BIS report above:
Duffie and Stein (2015): The Basic Idea of a Two-Benchmark Approach
2019 – ICE Bank Yield Index
2015 D&S: If we were starting from scratch, what might a more efficient and resilient set of arrangements for interest-rate benchmarking look like? The above discussion suggests that there could be considerable appeal in a “two-rate approach,” that is, two distinct types of interest-rate benchmarks. One of these, an improved version of LIBOR itself, would continue to be based on banks’ wholesale unsecured funding costs and would be appropriate for applications that rest on that credit risk component, such as hedging the revenues of balance-sheet lenders. This banking-oriented benchmark would be reformed to be transactions-based and subject to a tougher monitoring regime, and hence less subject to manipulation.
2018 – Secured Overnight Financing Rate (SOFR)
2015 D&S: The second benchmark would be based on a riskless or near-riskless rate that is established in a broad and deep market. The goal here would be to give pure interest rate traders—potentially a large fraction of the derivatives market—something that fits their risk-transfer needs well, while at the same time reducing the manipulation incentives that arise when so much rates-trading is tied to a rate like LIBOR that is based on the much thinner underlying market for unsecured bank borrowing.
What is the ICE U.S. Dollar Bank Yield Index?
In January of 2019, ICE benchmark Administration (IBA) put forward a White Paper introducing the U.S. Dollar Bank Yield Index (BYI). The BYI is based on both primary (e.g. inter-bank deposits, institutional certificates of deposit and commercial paper) and secondary unsecured, wholesale bond transactions of the bigger, international banks.
In the end, the goal was simple: to create an index that in many ways behaves like current day LIBOR:
1) Create a legitimate risk management tool for banks and end users (Libor)
2) Allow for measurement of unsecured bank funding costs (Libor)
3) Include forward looking rates with 1/3/6-month tenors in line with derivative, cash securities and bank loan structures
Following the ICE White Paper in January 2019, ICE published follow up papers in April, July and their most recent version in October after soliciting feedback along the way in terms of inputs, methodology and curve testing/regression versus current day LIBOR.
Let’s take a look at some excerpts from the October Update from IBA
How is the ICE Curve Constructed?
“Based upon feedback received on the white paper and the updates, indicating a desire to broaden the input data set used to derive the Index, IBA has decided to continue to develop and test the Index using an updated methodology based on a rolling five-day average of unsecured bank funding and bond transaction yields (subject to minimum transaction volume and transaction count thresholds). Each day of the input data collection window has been aligned to calendar days (i.e. the period between 12:00 midnight and 12:00 midnight Eastern Time on consecutive business days), rather than to the period between 11:00 am and 11:00 am UK time on consecutive business days used in the previous methodology”
“The use of a five-day window from which to collect data in order to calculate the Index should provide a larger and more diverse set of transaction yield information than the previous methodology, which should enhance the representativeness of the benchmark and help to ensure that it is consistently reflective of conditions in the wholesale, unsecured bank funding market”
What is the composition of the Primary and Secondary Transactions?
Upon initial feedback since the January White Paper, ICE has been working on revisions to methodology to best represent the largest pool of representative transactions for calculation purposes. Below are some of the updates and most recent notes from their October White Paper:
1) 5-day Rolling Average: In order to calculate the Bank Yield Index based on a rolling five-day average of transaction yields, the key data inputs required are:
2) Underlying transactional data over the five-day input data collection window: representative of the yields available to investors in both the primary funding and the secondary bond markets for senior, wholesale, unsecured U.S. dollar bank debt obligations.
3) Primary market bank funding transactions sourced from thirteen of the sixteen U.S. dollar LIBOR Panel Banks, which are subject to eligibility criteria including a minimum transaction size of USD 10 million, and allowable values for counterparty type, product type, maturity and funding location
4) Secondary market transactions in the bank level debt obligations of 30 large banking groups sourced from the Financial Industry Regulatory Authority’s™ (FINRA™) Trade Reporting and compliance Engine™ (TRACE™) which are subject to eligibility criteria including a minimum transaction size of USD 5 million, a minimum issuance size of USD 500 million, and allowable values for bond type, coupon range and maturity range. Bond transaction volumes are weighted to ensure that no issuer represents over 10% of the transaction volume used in the Index calculation, and bond yields are normalized to represent yield on a money-market basis.
What is the Alternative Reference Rates Committee Saying About the Bank Yield Index?
From a Deloitte US LIBOR Newsletter in October (Deloitte LIBOR Transition Newsletter), comments on the BYI from the ARRC, the private committee convened by the Federal Reserve Board and New York Fed to oversee the transition from LIBOR TO (SOFR):
“The ARRC does not have an official position regarding the use of the USD ICE Bank Yield Index parallel to separate to SOFR. The topic was discussed during the April 2019 ARRC meeting, which had presentations by the IBA and by David Bowman. The ARRC’s only official position is that the choice of SOFR was appropriate, and the ICE Bank Yield index would not have met the criteria that the ARRC set out when deciding on an alternative reference rate. It is still not clear how the ICE Bank Yield would behave or be published in times of market stress or if it will get hedge accounting status. The ARRC maintains that their recommendations are voluntary”
Market Behavior LIBOR vs SOFR
In following up on the performance statement (BYI) from the Deloitte interview above, the ICE BYI has been tested and regressed against LIBOR. Some of the sampling is included in the charts above. ICE has been clear, however, that differences in calculation methodologies between LIBOR and the BYI exist and “care should be taken when comparing US dollar LIBOR and the ICE Index on any day or period of testing”.
In terms of how the BYI (unsecured) would perform versus SOFR (secured), a reference back to the 2007/2008 makes this very clear. And although we are not suggesting a similar pocket of time is imminent, this dynamic is a concern for many market participants and should not be discounted within LIBOR conversion.
Chart below is 3-month LIBOR (Yellow) versus Treasury General Collateral (White). Clear divergence in 2008 whereas risk-free rates collapsed in a dramatic flight to quality, while LIBOR moved significantly higher. As we’ve been discussing, Dodd-Frank has changed the credit nature of LIBOR derivatives, yet it’s clear that other bouts of divergence have occurred along the way.
What’s Good for Some is Not Good For Others
As the expression goes, beauty is in the eye of the beholder. And depending on which end of the LIBOR transition one sits, the answers are quite different. At the core, the lack of credit sensitivity (secured versus unsecured) is a core theme and challenge amongst many market participants. And using the market turbulence of 2007-2008 as a reference, it’s very clear how LIBOR performed versus the risk-free rate.
Granted, with the evolution of centrally cleared derivatives credit sensitivity has declined, it remains an important part of a bank’s asset and liability management process when pricing risk, loans and cash flows.
1) From a lending perspective, a collective pool of bank funding rates allows for more efficient pricing of individual borrower credit with a rate that should directionally follow individual bank’s individual funding costs.
2) From a borrower’s perspective, a representative rate across a select group of large banks allows for more objective pricing evaluation.
3) Open lines of bank credit linked to a secured versus unsecured rate will likely present challenges in times of market stress and turbulence when funding costs and the risk-free rate diverge. This was seen most prominently, but not exclusively from 2007-2008.
4) Most cash assets and derivatives are priced with forward looking curves for cashflow and risk management purposes. This is a key component of current day LIBOR, with little workaround as SOFR would be a daily rate, compounded up with the rate unknown until the tenor end date.
What are Some Market Participants Saying?
On December 4th, the Wall Street Journal wrote an article titled “Regional Banks & SOFR. The article highlights the growing discomfort that many of the regional banks have expressed with concern over SOFR and its lack of credit sensitivity. To date, the ARRC has yet to put forward a solution to accommodate the credit sensitivity in LIBOR versus the risk-free rate. As we indicated before, this may not be of concern right now, but should the environment shift in the future with secured versus unsecured spreads widening, banks could be faced with legitimate asset/liability issues.
On September 23rd, a group of regional banks authored a letter to Randall Quarles, Vice Chairman of Supervision of the Board of Governors at the Federal Reserve. Let’s look at some excerpts from the letter:
1) We wholeheartedly support the efforts of the official sector and the Alternative Reference Rates Committee to facilitate an orderly transition away from the London Interbank Offered Rate (LIBOR) to the Secured Overnight Financing Rate (SOFR). We believe SOFR can and should be the liquid reference rate for most derivatives and debt products that currently reference LIBOR.
2) However, we believe that SOFR, on a stand-alone basis, is not well suited to be a benchmark for lending products and have concerns that this transition will adversely affect credit availability. LIBOR reflects unsecured inter-bank borrowing rates and accordingly contains a credit risk premium. During periods of economic stress, credit spreads on bank debt and other wholesale bank borrowings tend to increase, raising banks’ cost of funds.
3) During times of economic stress, SOFR (unlike LIBOR) will likely decrease disproportionately relative to other market rates as investors seek the safe haven of U.S. Treasury securities. In that event, the return on banks’ SOFR-linked loans would decline, while banks’ unhedged cost of funds would increase, thus creating a significant mismatch between bank assets (loans) and liabilities (borrowings).
4) In a SOFR-only environment, lenders may reduce lending even in a stable economic environment, because of the inherent uncertainty regarding how to appropriately price lines of credit committed in stable times that might be drawn during times of economic stress.
5) We believe a sensible and practical way to address these risks is to create a SOFR-based lending framework that includes a credit risk premium. That framework could consist dynamic spread that reflects changes in banks’ cost of funds over forward-looking term periods and is added on a periodic basis to SOFR-based rates.
Is the ICE Bank Yield Index the Only Alternative to SOFR?
No. A quick view from the smaller regional banks
The American Financial Exchange LLC, or AFX, is a niche operator located in Chicago and trying to carve out a role in the post-LIBOR era. Founded by Richard Sandor, the AFX Chairman is catering his contracts toward small regional and community banks.
The American Interbank Offered rate, Ameribor, is a benchmark interest rate calculated using transactions off the exchanges electronic marketplace which includes over 150 banks, insurers, broker dealers and other participants. Additionally, over 500 banks have access to the exchange through correspondent banks.
Like SOFR and the BYI, Ameribor is a transaction-based rate which also includes a credit component aligning it more closely with current day LIBOR.
Unlike the bigger banks that make loans in the billions, Ameribor is geared toward banks more closely aligned with lending in the millions. Regional banks in Alabama and Texas have already issued loans off Ameribor and find its closer alignment with LIBOR and their funding costs attractive. These banks do not typically own Treasuries, nor participants in the Repo market but have historically been active LIBOR users.
Chart Comparing LIBOR, SOFR and Ameribor