A BMR-shaped hole in the US Libor transition

US could benefit from copying EU Benchmarks Regulation as market moves to shaky Libor successors

When a string of US regulators attacked credit-sensitive Libor replacement rates in June, some were startled by the vitriol. Speaking of one of the benchmarks, known as BSBY, Gary Gensler at the Securities and Exchange Commission said it had “many of the same flaws as Libor” and that “there’s a heck of an economic incentive to manipulate it”.

The truth is, when it comes to reining in alternatives that closely resemble the discredited Libor benchmark, the SEC and the Federal Reserve have little more than hot air in their toolkits. Some believe the authorities may need more clout to manage the exodus from US Libor, the current reference rate for around $200 trillion of financial contracts.

“In the US, regulators have been driving the Libor transition on moral suasion rather than formal powers,” says David Lawton, a former senior UK regulator. “But as successor benchmarks spring up, there’s a question whether regulators will want to exercise additional formal powers to make sure that, having cleared the ground of all Ibor-based rates they didn’t like, weeds don’t spring up rather than flowers.”

One of the main reasons US supervisors dislike Libor successors such as BSBY, or the Bloomberg Short-Term Bank Yield Index, is they are not backed by a sufficient volume of transactions. This makes them vulnerable to rigging and also raises the risk they will become unrepresentative in the future if the underlying trades dry up – say, during a spell of market turmoil.

However, US regulators have no official power to stop firms using any particular benchmark at any point, as long as it complies with the voluntary standards from the International Organization of Securities Commissions. Of the five alternative US rates that contain the bank funding spread embedded in Libor, two are Iosco-compliant and the administrators of the other three are working towards alignment with Iosco.

There are far more financial services firms that use benchmarks than produce them. Therefore, if you want to use legislation to drive change, thinking about the users is a pretty powerful tool

David Lawton, former UK regulator

Momentum is building for new regulatory tools. In May, SEC commissioner Hester Peirce said she was open to exploring new rules for benchmark providers after the agency imposed a $9 million penalty on S&P Dow Jones Indices for violating a securities law. The enforcement action both revealed a need for clearer rules, as Peirce disagreed that S&P broke the law, and pointed to a new, more interventionist streak at the SEC.

In a separate process, the SEC is considering seeking public comment on the role of certain third-party service providers, including index providers, and the implications for the asset management industry.

And a bill that would force investment firms to be more transparent about their use of indexes is currently in the in-tray of a US Senate committee.  

But a more effective way to gain more control over benchmarks could be to adopt a version of the European Union’s Benchmarks Regulation, also onshored by the UK. The BMR requires benchmark administrators to comply with rules that are stricter than the Iosco principles and, in addition, places the onus on end-users to steer clear of rates that fall short.

Lawton, who was involved in developing the Iosco standards, highlights this second distinguishing feature of the BMR: “There are far more financial services firms that use benchmarks than produce them. Therefore, if you want to use legislation to drive change, thinking about the users is a pretty powerful tool.”

A rates trader at a large bank says some form of regulation to limit US use of flakier Libor replacements is “entirely possible”. As supervisors, the SEC and the Fed can exert influence on index providers and users respectively but, as the trader notes, “to truly prohibit something, you need legislation”.

Libor lookalikes

US dollar Libor is set to disappear in June 2023, though regulators have called for no new business to be written on it after the end of this year. US regulators’ preferred new benchmark is the Secured Overnight Financing Rate, built from a nearly trillion-dollar Treasury repo market.

But SOFR, a risk-free rate, lacks a bank funding spread, and lenders worry that SOFR loans could become unprofitable in times of stress, when funding costs can diverge from risk-free rates. As a result, interest in credit-sensitive benchmarks has been rising, particularly in the cash market – to growing alarm among supervisors.

In June, SEC chair Gensler took aim at the low trading volumes on which BSBY is based.   

“The median trading volume behind three-month BSBY is single-digit billions of dollars per day,” he said. “Like with Libor, we’re seeing a modest market shouldering the weight of hundreds of trillions of dollars in transactions. When a benchmark is mismatched like that, there’s a heck of an economic incentive to manipulate it.”

Photo: SEC

Gary Gensler

He added that the markets underpinning BSBY were not just thin in good times but “they virtually disappear in a crisis”.

The same day, Janet Yellen, US Treasury Secretary, expressed concern about the use of new benchmarks with low underlying volumes in derivatives markets. “The volume of derivatives contracts referencing these alternative rates could quickly outnumber the transaction volumes underlying the reference rate, leaving it vulnerable to manipulation,” she said.

To date, $1.9 billion of swaps linked to the Iosco-compliant BSBY rate have been traded, according to data from the Depository Trust & Clearing Corporation. As for the other Iosco-aligned rate, Ameribor, there has been one swap trade, totalling $24 million, although it does not show up in DTCC data.

Speaking alongside Yellen, Randal Quarles, vice-chair for supervision at the Fed, was softer in his criticism of alternatives to SOFR but still stressed that the rate should be the only one used in capital markets and for derivatives, and should play a role in other markets too.

Similarities between Libor and the five credit-sensitive alternatives help explain regulators’ discomfort. The rates are BSBY, Ameribor, Credit Inclusive Term Rate (Critr) along with a spread version, Bank Yield Index and – yet to start publication – AXI.

All five are derived from commercial paper (CP) and certificates of deposit (CD) – much the same data currently underpinning Libor. And back tests show that all four published rates track US dollar Libor with around 99% correlation (see box: Better than Libor?).

If you look at Iosco principles, they’re drafted wide and leave so much room for interpretation and discretion

Tobias Sproehnle, Moorgate Benchmarks

But US authorities have to contend with the fact that the rates are or are likely to be Iosco-aligned and so available to users.

The 19 Iosco principles are aimed at index providers. As part of the recommendations, compliant benchmarks should be overseen by a separate committee at the provider. Benchmarks should be anchored in functioning securities or derivatives transactions, and a hierarchy of inputs can be incorporated to ensure continuity. Fallback provisions should detail procedures in the event of benchmark cessation, while independent audits should be undertaken periodically to ensure adherence to the principles.

A benchmark can be deemed Iosco-compliant if its administrator establishes such compliance via an internal assessment or if it opts for a third-party judgement – typically carried out by a Big Four auditor.

The Iosco framework can be criticised on two counts.

“If you look at Iosco principles, they’re drafted wide and leave so much room for interpretation and discretion,” says Tobias Sproehnle, chief executive of Moorgate Benchmarks.

Highlighting this, Iosco compliance statements can vary widely in detail and length. For instance, German Index provider Solactive publishes a four-page statement, while FTSE Russell’s runs to 94 pages.

A benchmark can still be declared Iosco-compliant if it fails on one principle, providing the administrator can explain why this particular standard does not apply.

David Lawton

This flexibility in the voluntary standards is by design, according to Lawton, who is now a consultant: “The moment you say to people that it’s not an obligation, you need to make it feasible without a vast amount of effort.”

Secondly, with no clear policing system, the framework lacks teeth.

“There are questions about a framework where you can self-certify,” says a US-based Libor transition specialist. “You don’t get a fine if you miss out on one of the 19 principles. The Fed’s not overseeing that or making sure you’re implementing it. I think there could be more teeth to it and maybe that evolves over time.”

Beyond Iosco

There are other signs US regulators are craving bigger powers over benchmarks.

When the SEC penalised S&P – for failing to disclose a feature of the S&P 500 Vix Short-Term Futures Index that led to the publication of stale index values during a bout of extreme volatility – commissioner Peirce said the move “may hint at a deeper unspoken concern that index providers, whose products have become so integral to our securities markets, are not governed by a regulatory framework explicitly tailored to their activities”. S&P did not admit any wrongdoing.

According to Sproehnle at Moorgate Benchmarks, there has been a shift in the SEC’s approach to filings by exchange-traded funds in recent months, with the regulator looking more closely at the indexes underlying the funds.

“The SEC has been very detailed in terms of trying to understand how benchmarks are put together, what data flows into it and how conflicts of interest are managed. They are exerting more regulatory influence and a lot of questions around methodologies would sound like they’re coming from the FCA or Bafin,” he says, referring to regulators in the UK and Germany respectively, where the stricter BMR is in force.

The SEC’s possible consultation on the role of index providers and other service providers also shows a growing interest in benchmark administrators. The plan was revealed by the US Office of Information and Regulatory Affairs in spring, with no further details available at this stage.

The SEC may have been influenced by a January paper by Paul Mahoney from the University of Virginia and Adriana Robertson from the University of Toronto. The paper called for providers of indexes, mainly bespoke indexes, to be treated as investment advisers – given their role in designing the mechanisms underpinning $8.5 trillion of assets invested in US tracker funds – which would result in tighter regulation.

More scrutiny of indexes could come via another channel: the bill referred to the Senate’s Committee on Banking, Housing, and Urban Affairs in May would require investment firms to disclose more information, such as any role they had in designing indexes and any licensing fees paid to the index provider.

Unleashing BMR

The final option available to US regulators, if they wanted to have greater sway over the Libor transition, is to push for the adoption of BMR-like legislation.  

In contrast to the Iosco framework, the BMR requires benchmarks to meet every standard it specifies and sets a higher bar in other ways.

For example, while Iosco calls for appropriate internal oversight, the BMR expands this to require an independent oversight committee that should include employees not directly involved in benchmark provision and a balance of supervised users, contributors or external stakeholders. Failure to comply with BMR requirements can result in civil and criminal penalties.

“BMR is definitely one step deeper,” says Sproehnle at Moorgate Benchmarks. “It’s more detailed and much clearer in terms of what administrators can and can’t do.”

A financial institutions partner at a global law firm also notes the BMR’s potency, saying it “can give explicit prohibition on institutions’ use of certain non-representative benchmarks which don’t meet certain principles”.

The MAS is one of several regulators to adopt a lighter-touch approach by overseeing only some local rates

Indeed, the BMR gives regulators the power to stop approved benchmarks from being used in new contracts if they become unrepresentative – for instance, in the event of market structure changes that reduce input data. The UK’s Financial Conduct Authority has made full use of this power as it has been calling time on the various Libor settings it regulates.

US regulators do not have the same might, even though US credit-sensitive rates, built on CP and CD, are at risk of becoming unrepresentative. Money market reforms under consideration in the US may cause prime funds – key buyers of CP and CD – to reclassify as government money market funds, potentially dampening demand for the instruments. An earlier reform in 2016 slashed institutional demand for prime funds by more than 80%, according to Bloomberg data.

Yet the regulatory path is not straightforward. The BMR is a weighty piece of legislation, which has taken the best part of a decade to devise and implement. The rules are complex, far-reaching and laden with extraterritorial complications.

“Because BMR is so wide, it governs everything from the small research benchmark which a bank uses for a structured product all the way up to Libor,” Sproehnle says, adding that this “creates a lot of challenges”. For instance, the BMR’s tough demands on index providers could make some niche rates uneconomical to run.

[US regulators] need to be very careful in characterising this transition as market-led because … there’s a concern about allegations the government is thwarting private market activity

Lawyer at a global law firm

The US could head down a lighter-touch path adopted in parts of Asia-Pacific, where supervisors have chosen to oversee only some of the local rates. Singapore’s benchmarks regulation covers just two locally produced interest rates, Japan regulates only the Tokyo Interbank Overnight Rate, while Australia oversees five rates, including the ASX200 and a key interest rate benchmark, the Bank Bill Swap Rate.

“On the face of it, the Singapore model makes senses because you only regulate what’s critical to the financial infrastructure,” Sproehnle says. “But it can get quite messy from an equivalence perspective if you have jurisdictions where you have broad regulation and others where it only applies to a handful of benchmarks.”

For example, a non-EU administrator could be locally regulated for a critical interest rate benchmark, but the rate could be used across the EU via an equivalence agreement. Yet the same administrator would need to be regulated in the EU or other jurisdictions to sell other benchmarks that do not fall under local rule.

But even copying the BMR in some form is not guaranteed to solve US regulators’ problem with benchmarks that are based on insufficient transaction volumes. Euribor, an EU interbank benchmark, has been deemed BMR-compliant – albeit under an updated waterfall methodology – even though it is based on just €5 billion ($5.9 billion) of daily transactions and, like Libor, often relies on expert judgment.

Risk.net asked the SEC and the Fed whether they were considering adopting rules similar to the BMR, but they did not respond.

There may be a good reason for the regulators’ reticence.

“They need to be very careful in characterising this transition as market-led because they do lack authority and there’s a concern about allegations the government is thwarting private market activity,” says the lawyer at the global law firm.

“The underlying thesis is that the government can’t tell the market what rate they should lend to.”

Better than Libor?

Libor’s failings stemmed from a scarcity of unsecured interbank funding transactions since the 2008–09 financial crisis. This forced the rate to rely on estimates of what banks might charge in a market that barely existed. Although Libor’s methodology has since been upgraded so the rate is built from CP and CD at the top level of inputs, levels two and three – extrapolation and judgement – are still commonplace when underlying volumes are low.

The new Libor lookalikes eliminate judgement by maximising transaction data through the use of multi-day windows. For instance, if a BSBY tenor does not meet its minimum volume threshold – based on the average daily volume over the past three days – the lookback period is extended up to a maximum of five days until the bar is reached.

Still, the minimum thresholds for the credit-sensitive alternatives are just a fraction of the $900 billion of daily Treasury repo volume underpinning SOFR. BSBY’s highest threshold, for its less well-used overnight setting, is only $60 billion, while the daily threshold for the three-month Critr tenor is just $1.5 billion.

A forward-looking term SOFR rate, awaiting official endorsement, is underpinned by $200 billion of daily SOFR futures volume. And term SOFR is already certified as compliant both with the Iosco standards and the BMR.

Ameribor and BSBY are certified by third-party auditors to comply with all 19 Iosco principles, but neither has yet issued a statement of BMR compliance.

Ameribor’s publisher, the American Financial Exchange, has no current plans to seek BMR registration given the rate’s niche focus on US regional banks.

BSBY’s UK-regulated administrator is in the process of creating an independent oversight committee in an effort to comply with the BMR in the UK, enabling local firms to use it. The rate is currently available to EU users as a third-country benchmark until the end of 2023. After this time, BSBY will need to be included on an official third-country benchmark register for use by EU-supervised entities. As of now, the rate is not listed on the register.

IHS Markit is yet to issue a formal statement of Iosco compliance for its US dollar Critr benchmark, which can be used on its own or as a spread to be layered over SOFR, called Credit Inclusive Term Spread. The benchmark provider says it is working towards administering both in compliance with the UK BMR and Iosco.

Ice Benchmark Administration publishes its Bank Yield Index only in beta testing mode, meaning it is not yet available for use in contracts. The administrator is negotiating data agreements with Libor panel banks to make the rate live, which is one of the steps towards Iosco and BMR compliance. While some banks are keen to get the rate up and running, others are understood to be reluctant since US and UK regulators have expressed disapproval of credit-sensitive benchmarks.

SOFR Academy, which plans to start publishing its across-the-curve index, or AXI, during the third quarter, expects its rate to comply with both the Iosco principles and the BMR.

Editing by Olesya Dmitracova