By Paul Noring
The clock is ticking down to the end of 2021, when the London Interbank Offered Rate is no longer guaranteed to be available as a reference rate. With Libor underpinning close to $200 trillion in financial contracts in the United States alone (and more globally), global regulators and banks alike have been eager to find replacements for Libor that can serve as a suitable benchmark rate across all major currencies.
In the U.S., the Alternative Reference Rate Committee—a group of market participants convened by the Federal Reserve—has selected the Secured Overnight Financing Rate as its preferred Libor heir, and the ARRC is currently creating resources and fallback language to help banks understand the new rate and transition their contracts to SOFR. Getting there by Jan. 1, 2022, will require a herculean effort to ensure a smooth transition.
In the meantime, market participants may find that other alternative benchmarks suit their needs better for certain products. Now is the time for banks to analyze the reference rate scene and begin making their transition plans.
SOFR: the ARRC’s preferred alternative
SOFR (see table 1) is a secured rate and represents the costs of funds in the overnight repurchase markets. Whereas Libor is an unsecured rate with a dynamic credit spread, SOFR is a secured rate there is a view that in times of significant market stress that rate will decrease and borrowers will pay a lower rate to banks, whereas banks’ cost of funds will rise. This could compound safety and soundness issues by decreasing net interest margin at the same time there is significant credit deterioration. This concern was highlighted by two separate groups of regional and midsize banks in letters to the regulatory agencies.
Table 1: Key Differences Between SOFR and Libor
|Currently only an overnight rate||Up to seven tenors, extending up to one year|
|Interest most likely calculated in arrears||Interest calculated in advance|
|High daily volatility given issues in repurchase market||Low daily volatility|
|Based on actual transactions||More of a hypothetical rate (limited transactions)|
Other key issues include those highlighted in table 1. One of which that has been discussed at length among participants responsible for conversion efforts are the operational challenges of moving to SOFR. Specifically, for loans currently rely on an advanced Libor rate—that is, the rate on the reset date will be the rate for the next period, in contrast with SOFR—the ARRC is moving toward the opposite approach where an in-arrears calculation may prevail. If this approach is adopted as expected, rates for the period would only be known at the end of the period. Moving to an in arrears calculation approach will require massive changes to current lending and borrowing processes and systems.
SOFR also poses challenges related to its volatility compared to Libor and other alternative benchmarks. Since SOFR is tied to repo agreement lending, the rate has also experienced increased volatility particularly around quarter-end and large treasury auctions (see figure 1). For instance, certain transactions exceeded a 9 percent overnight rate in September 2019, and the Federal Reserve had to step in with highly public market–stabilizing transactions in order to bring the rate into a more reasonable range. SOFR as a replacement for Libor in the derivatives market is going more smoothly. But one may not fit all for consumer and commercial lending products.
Figure 1 – SOFR Rates
Three possible alternatives have emerged, each of which has—unlike SOFR—a dynamic credit spread. None is currently an ideal replacement, but all have significant promise.
- Ameribor. This new interest rate benchmark created by the American Financial Exchange reflects the actual unsecured borrowing costs of over 1,000 American banks and financial institutions. Transaction volume has steadily increased, and the rate has proved to be much more stable than SOFR even during periods of quarterly volatility.
- Bank Yield Index. To be published by ICE, which also publishes Libor, it is a forward-looking, credit-sensitive benchmark designed specifically as a potential replacement for Libor for U.S. dollar lending activity. The index seeks to incorporate some of the key properties of Libor that cash market participants have said they would like to retain in a U.S. dollar lending benchmark.
- Commercial Paper Rates. The Federal Reserve Board of Governors publishes daily commercial paper rates derived from data supplied by the Depository Trust and Clearing Corporation, a national clearinghouse for the settlement of securities trades and a custodian for securities. DTCC performs these functions for almost all activity in the domestic CP market.
Some of the advantages and limitations of each of these alternatives is highlighted in table 2.
Table 2. Alternative Rates Advantages and Limitations
True interbank lending rate
Good market depth, with more than 100 banks participating daily with as much as $3 billion in daily transactional activity
Regulated futures contract currently trades and ability to obtain cash flow hedge accounting
|To date, predominantly an overnight rate, with no meaningful term structure / forward rates
Activity to date has been with midsize and regional banks; not yet used by top 30 or global internationally active banks
|ICE Bank Yield Index||Administered by a premier global exchange
Specifically designed to measure the average yields at which investors willing to invest U.S. dollar funds over on-month, three-month and six-month periods on a wholesale, senior, unsecured basis in large internationally active banks
|Currently, not IOSCO–compliant
Methodology was fluid during 2019; changed several times
To date, only test publication of rates; unlike Ameribor or actual Commercial Paper issuances, no transactions tied to the rate
|Commercial Paper Rates||Published daily for AA financials by the Federal Reserve Board of Governors
Derived from actual transaction data supplied by DTCC
Forward looking with term structure
|Currently, not IOSCO–compliant
On certain dates, trade data maybe insufficient to support calculation of a particular rate
Includes all financials not just inter-bank lending
Primary purchasers of CP are money market funds (therefore not interbank lending or borrowing)
With global regulators remaining adamant that banks should plan for a Libor cessation after 2021, two things are crystal clear about the replacement rate for commercial and consumer loans. First, many market participants are looking for a dynamic credit spread to ensure the safety and soundness of all but the largest U.S. banks; and second, it must be a forward-looking rate, as there is absolutely no way all commercial and consumer loan systems and processes can be changed in time to avoid material operational issues. Since time is of the essence, any existing and new working groups formed to study this issue should not delay. With emergent alternatives besides SOFR, market participants should start or expand their testing of the waters with actual transactions tied to these alternative rates.
Paul Noring is a managing director who leads Berkeley Research Group’s financial institution advisory practice, where he is currently focused on supporting clients with Libor transition activities.