SOFR alternatives remain on track despite regulatory warnings

Pointed criticism from FSOC has done little to dampen interest in credit-sensitive rates

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Banks and index providers still plan to offer a menu of Libor replacements for use in loans and derivatives contracts despite recent regulatory criticism of credit-sensitive alternatives to the secured overnight financing rate, or SOFR.

Senior US supervisors railed against the use of credit-sensitive benchmarks in derivatives contracts at a June 11 meeting of the Financial Stability Oversight Council. Securities and Exchange Commission chair Gary Gensler was especially scathing about Bloomberg’s Short-Term Bank Yield index, or BSBY, which he said suffered from “many of the same flaws” as Libor.

Gensler warned against recreating Libor’s “inverted pyramid” – where $200 trillion of derivatives contracts rested on just $1 billion of underlying transactions – which he said made it vulnerable to manipulation.

SOFR, on the other hand, is based on $900 billion of daily volume. 

Umesh Gajria, global head of index-linked products at Bloomberg, rejects the idea that credit-sensitive benchmarks are susceptible to manipulation. He points out that the new rates dispense with the ‘expert judgement’ that undermined Libor and are built largely from primary bank funding transactions, such as commercial paper and certificates of deposit. 

“Given that BSBY isn’t designed to rely on subjective input, it’s extremely difficult to manipulate,” he says. “One of our biggest requirements was to make sure this rate is highly robust.”

Nor does he think the regulators’ broadside will deter lenders and borrowers from adopting alternatives to SOFR. “Our clients are looking at their own customers and investors and trying to do the right thing. For many, the use of BSBY in lending markets is the right thing and it is within the rule set as we’ve seen publicly,” says Gajria.

Banks also seem unmoved. A senior rates trader at a large US bank says his firm will continue to support at least some credit-sensitive benchmarks “as long as the rates are robust and have good governance, which we think they do”.

A rates trader at a second US bank says the harsh words from regulators are unlikely to quash client demand for credit-sensitive rates that look and feel more like Libor: “It’s a bit too early to tell, but the impression so far is that no one’s behaviour is materially changing.”

The senior rates trader at the first US bank says the regulators’ comments have only served to inject “more confusion and uncertainty into the market with less than seven months until the business needs to be off Libor”.

Even if multiple banks were to make huge trades way off market, it does not manipulate the rate

Umesh Gajria, Bloomberg

While US dollar Libor will continue to be published until June 2023 for use in existing contracts, regulators have called for no new Libor business to be written after the end of this year. But some parts of the market have been slow to embrace SOFR, the regulator’s preferred Libor replacement, with many lenders expressing a preference for credit-sensitive alternatives that replicate the bank funding spread and forward term structure embedded in Libor.

“From an ALM perspective, banks and corporates find it much easier to manage a balance sheet with rates that are highly correlated with Libor,” says Navin Rauniar, partner for Libor transition at consultancy TCS. “Regulators can make as much noise as they like, but unless they enact something into federal and state law to prohibit the use of these rates, nothing is going to change.”

Interest in BSBY has grown steadily since it launched in March, especially among large banks. Bank of America issued a $1 billion six-month bond referencing the rate in April and led the first syndicated loan linked to the benchmark – a $150 million revolver for workwear company Duluth Holdings – the following month.

The first BSBY derivative – a $250 million basis swap between BSBY and SOFR – was traded by Bank of America and JP Morgan in May. This has been followed by more than $1 billion notional in swap transactions, including fixed-to-float instruments out to 10 years.

Ameribor, a benchmark based on unsecured overnight loans transacted on the American Financial Exchange, has also been gaining traction with US regional banks. Richard Sandor, founder and chief executive of the AFX, doesn’t believe the regulatory criticism of credit-sensitive benchmarks will change that.

“It’s very much business-as-usual,” he says. “We represent all banks, large and small, and in any given day the volume is large and the breadth is wide. The extent to which there was criticism, it wasn’t levied at regional, mid-size, community or minority banks, which Ameribor serves.”

Utah-based Zions Bank, which has more than $80 billion in assets, has committed to begin using a 30-day version of Ameribor for commercial lending later this year. Other regional players are eying adoption from the third quarter of this year.

In February, Federal Reserve chair Jerome Powell said Ameribor was “fully appropriate” for banks that either fund themselves through the AFX or have similar funding costs to those that do.   

Anti-manipulation measures

The new generation of credit-sensitive rates are underpinned primarily by unsecured wholesale bank funding transactions, such as commercial paper and certificates of deposit. Issuance of these money market instruments has halved since the 2008 financial crisis as financial institutions reduced their reliance on unsecured short-term funding.  

Given the scarcity of transactions, providers of credit-sensitive benchmarks have resorted to padding out their input volumes with multi-day lookback windows. The three-month version of BSBY uses a three-day moving average to reach a $10 billion volume threshold. This data is supplemented with executable quotes. The lookback period can also be extended to five days during times of low liquidity to bolster the calculation.  

Additional checks and balances have also been incorporated to stamp out possible manipulation. For instance, none of BSBY’s 34 contributing banks can represent more than 20% of the overall volumes used to calculate rate. Off-market outliers are also removed.     

In a hypothetical test scenario, where Bloomberg moved executable offers for two of the top five contributing banks by 20 basis points, the impact was small. On the downside, the three-month rate changed by less than 1bp, while on the upside it shifted by less than 0.4bp.

Benchmark specialists say manipulation of BSBY and similar indexes would require collusion not just among several banks, but also between traders and the treasury departments responsible for primary issuance. Even then, the prices used to calculate the benchmarks would reflect actual funding transactions, rather than indicative quotes.  

“Even if multiple banks were to make huge trades way off market, it does not manipulate the rate,” says Gajria. “If every bank in the world is issuing commercial paper at a particular rate, that’s the market rate.”

Turning up the volume

Some market insiders suspect the harsh tone at the FSOC meeting may have been intended to stave off adoption of credit-sensitive benchmarks until a forward looking term SOFR rate becomes available.

In March, the Alternative Reference Rates Committee, the Fed-backed group tasked with weaning US markets off Libor, said it would be unable to meet a June target for recommending a term SOFR rate. Less than two months later, CME was confirmed as the official provider of such a rate. An endorsement is now expected in August, coinciding with a ‘SOFR first’ initiative aimed at getting dealers to use SOFR when quoting dollar swaps in the broker market.

However, it remains unclear how widely a term SOFR can be used in cash markets or whether it will be available for derivatives hedging instruments.

“There remains a significant portion of the market that needs a forward-looking term rate, and if SOFR doesn’t have one that can be widely used, people are going to look for alternatives,” says the first rates trader.

The criticism of credit-sensitive benchmarks also comes as regulators fret about flagging SOFR liquidity. In May, just 6.9% of US dollar swaps volume by traded risk referenced the regulators’ preferred replacement rate. This figure may even overstate true activity, as SOFR/Fed funds basis swaps make up a large portion of current volumes.

While US regulators have steadfastly backed SOFR, some officials have been careful not to rule out alternatives. At a May 11 SOFR symposium, John Williams, president of the Federal Reserve Bank of New York, said regulators would be comfortable with a multi-rate environment, providing it was built on a solid SOFR foundation. “With that foundation securely in place, we can build a house with an assortment of reference rates that can meet the specific needs of particular borrowers and lenders,” he said.

In its official FAQ document, the ARRC also states its support for a “vibrant and innovative market with reference rates that are robust, Iosco compliant and available for use before the end of 2021”.

Matt Hoffman, a director at Chatham Financial, says that while regulators have turned up the volume, their recent comments are consistent with the wider stance they have taken to date. “While there’s been a recognition that there may be different scenarios where different rates will make sense, particularly as credit-sensitive rates have continued to develop, it’s not surprising to see the ARRC gradually turning up the volume on the message that it’s really SOFR that they think is most appropriate.”