Gill Wadsworth provides a progress report on the alternative reference rates that have replaced the old benchmark.
It has been a decade since several big-name banks were caught up in an interest rate fixing scandal. Not only did several culprits serve jail time, but the episode resulted in a total overhaul of the system in which banks are able to lend to one another, and the rates at which individuals pay on mortgages and other loans.
Gone is the London Interbank Offered Rate (Libor), to be replaced with a range of alternatives designed to provide greater transparency, and be less vulnerable to meddling by a handful of unscrupulous bankers.
The path to a new lending rate has been far from straightforward and has proven something of a headache for the financial service firms tasked with rewriting – or repapering – the estimated US$350 trillion contracts currently benchmarked to Libor.
For regulators, too, the switch has been far from easy. A report from ratings agency CISRIL notes the numerous questions regulators had to answer. “Should the rate reflect uncollateralised or collateralised lending? Should it be an overnight rate or a term rate, and if a term rate, what should be the term(s)? Should it be based on actual market transactions or rely on discretionary submissions? Should it reflect credit risk like LIBOR, or should it be a risk-free rate like an overnight index swap?”
Substitutions
The response has been to set a range of alternative reference rates (ARR) that regulators believe correspond to various key financial markets (see Figure 1).
“There has been a lot of progress in the past few years as industry and governing bodies clarified the mechanics of IBOR replacement in contracts,” says George Petropoulos, chief product officer, pricing & risk at Delta Capita. “The industry is keen to move on and leave IBORs behind.”
These replacements, however, cannot match LIBOR precisely since they measure the actual overnight interest rate, while the old system was set by bankers based on projected rates to reflect loan terms.
The CISRIL report states: “For loan contracts, shifting from a forward-looking term rate to a backward-looking average of the overnight rate is difficult. Participants desire a forward-looking rate to reduce uncertainty of the compounded overnight rate that would be known at the end of the period. In such cases, transitioning from IBOR would require a forward-looking term rate. The backward-looking feature could hinder adoption of the RFR.”
In July 2021, the Alternative Reference Rates Committee (ARRC) formally recommended CME Group’s forward-looking term SOFR rates estimated for one-, three-, six- and 12-month tenors.
Petropoulos says, “The ARRC and others have endorsed SOFR and recently CME’s term SOFR as the alternative reference rate. The latter is a key development as market participants were looking for a term rate to be used for products such as credit facilities and loans, which are difficult to transition to an overnight rate. This development is addressing one of the major shortcomings of SOFR and, so far, the market has taken this development well.”
While the market may have taken this well, Peter Woeste Christensen, director at capital markets technology and consulting firm LPA, says the ‘engineered’ term SOFR rate is not without challenges.
“The loan contract says it is based on US dollar LIBOR and under the new regulations the contract will be switched to SOFR. But if SOFR is trading above LIBOR, you have to say to the client they are now paying more for that product. It’s a difficult conversation to have.”
CISRIL says lenders are also concerned that SOFR may not reflect the correct cost of funding, particularly in times of stress since it is a risk-free rate.
Alternative indices are available to help gauge the credit risk. These include the Bloomberg Short-Term Bank Yield Index (BSBY); Ameribor (see boxout); ICE Bank Yield Index (BYI); IHS Markit dynamic credit spread; and Across-the-Curve Spread Index (AXI).
Petropoulos notes, “Market participants have a preferred rate and convention by product type. As a result, market participants would have to manage any mismatch created using different rates and conventions.”
He adds: “The fact that SOFR is less volatile than credit sensitive rates is not a disadvantage. Market participants need to spend some time understanding their risk profile resulting from using any of the rates available to them.”
But, as Petropoulos warns, there is less than a year before one-, three-, six- and 12-month US Dollar LIBOR panels cease to exist, and he says market participants “must be well on their way” to understanding and actively managing their books, repapering of contracts at scale; and performing client outreach to mitigate reputational risks.
He concludes, “Financial institutions have put a lot of resources to support the transition and are now in what is probably the final phase but also the most important phase. It is important for all market participants to be ready to use all the available rates and conventions as there is no certainty as to which rate will prevail across all products.”
The future for Ameribor
The Secured Overnight Financing Rate (SOFR) is set to be the dominant reference rate as US financial institutions switch out of LIBOR.
SOFR is based on transactions in the Treasury repurchase market and, while preferable to LIBOR since it is based on real transactions, is widely seen as better suited to large US-based banks.
Consequently, European and UK-based institutions are likely to use their own rates – the euro short-term rate and the sterling overnight index average respectively – but this leaves mid- and small-sized US institutions unserved.
Reed Whitman, treasurer at Brookline Bancorp, says that offering SOFR does not always make sense for his bank’s book of loan contracts.
“The SOFR market is dominated by the Federal Reserve, and they are the 100-pound gorilla which is essentially setting and pegging the rate and it’s not reflective of what we borrow, and it is not a market rate that is relevant for us,” he adds.
Whitman prefers to use Ameribor which is determined by overnight unsecured lending on the American Financial Exchange (AFX). Ameribor is based on unsecured loan transactions among US based financial institutions such as Federal Home Loan Banks. Ameribor gives smaller banks the ability to benchmark at a different rate, according to Petropoulos, “The level of Ameribor is higher even when SOFR is adjusted by a credit adjustment spread and they behave differently during periods of market volatility.”
Whitman says this is critical to meeting his clients’ contracts. “That choice is important; we want to offer our customers the risk-free rate on SOFR, but we also want to offer them a rate that’s credit sensitive because we can we offer them a lower spread, he says.
Ameribor’s future in a SOFR-dominated world will depend on its continuing relevance to the mid-tier American banks.
