A U.S. Libor Replacement with Traction

The big‐bank replacement for the London Interbank Offered Rate (Libor), known as SOFR (Secured Overnight Financing Rate), is working through some growing pains and development issues, including the construction of a term rate and its secured nature. Meanwhile, an alternative risk‐free rate aimed at regional lenders is gaining momentum - and a higher profile.

It is happening on the American Financial Exchange (AFX), an interbank lending platform led by veteran market-and-trading innovator Richard L. Sandor. AFX's transaction volume remained relatively muted from its 2015 launch until the first quarter of 2018, when it began a steep climb. It reached average daily volume of $1.431 billion in this year's first quarter, compared to $356 million a year earlier. On April 15, 2019, trading volume hit a record $2.522 billion, 7% higher than the previous mark, on March 28.

From these transactions, AFX generates the Ameribor benchmark for pricing loans and other financial products tied to banks' cost of funds. With Libor potentially disappearing after 2021, when the last remaining global banks obligated to submit their interbank borrowing rates will no longer have that obligation, Ameribor could become the replacement for a sizable swath of lending institutions.

One of AFX's early participants, Signature Bank of New York, lists Ameribor as a replacement for Libor, which today, after 33 years, is the benchmark for upwards of $20 trillion in floating-rate financial products.

“We've closed transactions where [Ameribor] is the back-up rate to Libor, and an alternative rate when Libor goes away,” said Scott Shay, chairman of $48.6 billion-in-assets Signature Bank.

Below the Top Tier

Although not off limits to large banks like those now moving toward SOFR, AFX and Ameribor are aimed specifically at midsize and smaller banks and nonbanks in the U.S., according to Dr. Sandor. The AFX chairman and CEO's earlier pioneering includes the first interest-rate futures contract at the Chicago Board of Trade and, through Environmental Financial Products, incubating the Chicago Climate Exchange, European Climate Exchange, Chicago Climate Futures Exchange (their holding company Climate Exchange was acquired in 2010 by Intercontinental Exchange) and Tianjin Climate Exchange.

“The focus is regional midsize and community banks because we want to have something that clearly represents the cost of funds within that group, and that's very different from a JPMorgan or Citibank,” said Sandor, who looked back and ahead at financial market innovation in a 2018 book, Electronic Trading and Blockchain: Yesterday, Today and Tomorrow.

Sandor said that SOFR is a critical step in the transition away from Libor and represents a significant segment of the U.S. financial sector. “The Fed provided important leadership at a crucial moment, and SOFR is a key development,” he said.

However, he added, U.S. institutions that are not systemically important financial institutions (SIFIs) have unique characteristics and banking dynamics that may require an unsecured benchmark corresponding to these specific conditions. Libor and SOFR are impacted by factors outside the U.S., such as the credit issues of European banks lending in U.S. dollars.

Targeting Growth

As of mid-April, the AFX counted 141 institutions - 116 banks and 25 nonbanks - each with less than $150 billion in assets, either buying or selling funding via the exchange's web‐based electronic matching engine. An additional 557 banks have access to the exchange through correspondent banking relationships. Sandor said AFX's goal is to provide access to 1,000 banks by year‐end.

Approximately 12% of U.S. banks, with $1.8 trillion in aggregate asserts, currently have access to AFX.

AFX in December announced its first corporate member, Deere & Company, along with 20 other nonbank members including insurance companies, broker‐dealers and asset managers.

AFX loans are transacted on the basis of standardized loan agreements. Market surveillance and compliance is conducted by Cboe Global Markets, which is regulated by the Securities and Exchange Commission and Commodity Futures Trading Commission. Sullivan & Cromwell provides regulatory counsel.

Secured versus Unsecured

JPMorgan, which has $2.7 trillion in total assets, is in the forefront of those pushing for SOFR, which was chosen by the Alternative Reference Rates Committee (ARRC) in 2017 to replace Libor. SOFR, derived from thousands of secured overnight repo transactions, is thus very difficult to manipulate, a primary reason for its selection by the ARRC.

Similar to Libor, Ameribor is an unsecured rate that incorporates credit risk, so banks' cost of funding will move in tandem with the benchmark over which they price their loans. When banks' cost of funds increases during periods of credit stress, that rate will also rise.

“Because Ameribor represents the cost of funding, assets linked to Ameribor are automatically hedged,” Sandor said. “It's a perfect match.”

SOFR, because it is a secured rate, in periods of credit stress is more likely to decrease as investors see safety in secured assets, resulting in banks' cost of funding increasing while the interest they collect on their loans falls.

Perceived Advantages

“If we had used SOFR as a reference rate during the 2008 financial crisis, our loans would have been seriously underpriced, and our cost of funds would have been higher than what we were charging on our loans,” said Tom Broughton, chairman, president and CEO of $8.3 billion‐in‐assets ServisFirst Bank, a 13‐year old commercial bank based in Birmingham, Alabama, with offices in 10 southeastern cities.

He said that ServisFirst is a net seller of funds over AFX, averaging $200 million nightly, and that its funding primarily comes from depositors. In February it priced an $8 million commercial real estate loan over Ameribor that has a five-year maturity and 15‐year amortization. It has priced lines of credit as big as $10 million with the benchmark, the CEO said, adding that bank currently has a number of Ameribor‐priced proposals outstanding and is trying to accelerate use of the index.

“We explain to customers that Ameribor is a new reference rate that's a bit higher than Libor but is very steady compared to SOFR, and that Libor can be manipulated while Ameribor can't,” Broughton said.

The average spread between Libor and Ameribor over the last six months has been 17.5 basis points, he said, so if a borrower's loan prices at 200 basis points over Libor, it will be 182.5 basis points over Ameribor.

To assuage any concerns about using such a new benchmark, “we simply put in the loan documents that if there's ever a technical issue with Ameribor, we'll pick a new reference rate,” Broughton said.

“Important to Have Alternatives”

Shay said Signature Bank, which focuses on small and midsize businesses, has been both a buyer and seller of funds over AFX, in part “because we think it's important to have alternatives to the big‐bank oligopoly.”

He said only a small percentage of Signature's funding comes from AFX; most comes from deposits. The bank has yet to use Ameribor to price loans, although it has started talking to customers about doing so.

The Federal Reserve Bank of New York, which sponsors the ARRC, began publishing SOFR in April 2018, and soon after that CME and other major exchanges fostered markets in SOFR futures and cleared swaps. Starting last summer, several quasi‐governmental institutions such as Fannie Mae and large financial institutions issued debt priced over SOFR, with Mizuho Americas in February offering a $200 million, floating rate CD carrying a six‐month maturity.

Jump in Futures

The average daily contract volume of the CME's one‐month and three-month SOFR futures has leaped this year, to 134,917 in March from 18,384 in January. That bodes well for the ARRC's plan to use derivative contracts as building blocks for a forward-looking term version of SOFR, which will make it easier for borrowers whose debt is priced over Libor, a term rate, to transition to the new benchmark.

The AFX also plans to use futures to develop a term structure for Ameribor, to provide borrowers with forward-looking versions of the rate that resemble their current loans priced over Libor. (Larger commercial loans, for example, are typically priced over three‐month Libor.)

“We will launch futures on Ameribor that will be the unsecured versions of the SOFR futures products listed on the CME,” Sandor said. “We're targeting third quarter.”