On the Road to the Libor Transition: New Solutions Sought and Proposed
Efforts are underway to layer credit risk on SOFR; more banks are using the Ameribor alternative but are looking for hedges
Friday, September 25, 2020
By John Hintze
While heeding regulators' insistence that they move away from the London Interbank Offered Rate (Libor) benchmark by the end of 2021, U.S. banks are facing the fact that the Federal Reserve-supported Secured Overnight Financing Rate (SOFR) does not reflect credit risk. Solutions are percolating but unlikely to arrive before corporate debt begins transitioning from Libor.
Meanwhile, American Financial Exchange's (AFX) Ameribor is being used to price corporate loans, and an indicative, 30-day forward rate, Ameribor30, is being introduced to provide borrowers with greater certainty about future interest payments.
“When regulators ask, 'What is your transition plan?' we say we don't have one - we have already transitioned,” said Thomas Broughton, chairman and CEO of ServisFirst Bank of Birmingham, Alabama. “As of January this year, we eliminated using Libor and entirely converted to Ameribor” for new and renewing loans.
ServisFirst, the lead subsidiary of $11 billion-in-assets ServisFirst Bancshares, is one of numerous regional lenders attracted to Ameribor.
On September 9, when AFX announced Ameribor30, ServisFirst was said to be the first to use it, in pricing a $20 million loan. The forward-looking benchmark “aligns with macroeconomic theory and academic research on the term structure of interest rates,” AFX said.
Other banks are also pricing corporate loans over Ameribor, according to Richard Sandor, the renowned futures market innovator who is chairman and CEO of Chicago-based AFX, but he declined to name them.
The traction gained by AFX - the five-year-old interbank funding exchange reached the $1 trillion transaction milestone on June 25 - earned recognition from Fed chair Jerome Powell for Ameribor as a “fully appropriate alternative for banks when it reflects their cost of funds.”
Powell's statement in a May letter to Senator Tom Cotton, Republican of Arkansas, “reinforces the importance of choice in the use of benchmarks and is key to the development of SOFR and Ameribor,” Sandor said in a statement. “Both are complementary to each other and offer robust alternatives as the market transitions away from Libor.”
Sandor added that other statements by Fed officials and the Federal Reserve Bank of New York-hosted Alternative Reference Rate Committee (ARRC) “provide greater impetus to Ameribor as it becomes a viable replacement for Libor.”
Although the nation's largest institutions use SOFR to price their own, short-term securities, they have yet to offer the rate regularly to corporate clients.
SOFR is derived from overnight repurchase-agreement transactions totaling hundreds of billions of dollars in volume, making it difficult to manipulate - a key objective for regulators after coming to grips with Libor's deficiencies. However, the regional banks have been drawn to Ameribor because they found SOFR doesn't reflect their cost of funds. And unlike both Libor and Ameribor, SOFR is a secured rate that does not incorporate credit risk and so is likely to tighten in volatile periods, when market participants seek safety.
ServisFirst's Broughton called it “ludicrous” to adopt “an index that will plummet while our funding costs go up.”
Across-the-Curve Credit Spread Indices, a working paper published in July, addresses that concern by describing a “preliminary approach to designing an across-the-curve credit spread index (AXI)” that can be layered on top of SOFR. Stanford University finance professor Darrell Duffie, one of three co-authors, said it was prompted by his participation in Credit Sensitivity Group workshops where bankers and regulators discussed the Libor transition.
“When we understood what the banks were asking for and that the other things on offer may be deficient, we decided to put out this idea,” Duffie said.
An ARRC best practices document, published in May, recommends no longer using Libor to price floating-rate notes by year-end, and business loans, securitizations and derivatives by June 30, 2021. Although the AXI concept almost certainly could not be applied in that timeframe, Duffie said, it could later serve as a tool to mitigate any remaining credit risk concerns.
Proposed ICE Index
ICE Benchmark Administration (IBA) introduced a similar idea in a January 2019 white paper on the U.S. Dollar ICE Bank Yield Index. The index seeks to reflect banks' cost of funds derived from wholesale, unsecured, primary-market funding transactions, including interbank deposits and institutional certificates of deposit, and commercial paper transactions. Similar to AXI, the index would create a credit spread to layer on top of SOFR, providing variability reflecting banks' cost of funding.
In a May 2020 update, IBA listed goals including establishing a governance and control framework for production of the index and an operational framework to produce the index in the U.S., in hopes of launching the U.S. Dollar ICE Bank Yield Index later this year.
IBA issued a separate proposal, in a July white paper with Tradeweb Markets, for daily Tradeweb ICE Constant Maturity Treasury Rates (Tradeweb ICE CMT Rates) “to provide market participants with a daily overview of U.S. Treasury yields for standard maturities.” Daily published rates along the maturity curve “could potentially provide borrowers and lenders with a choice in benchmark term risk free rate settings,” the paper said. “Furthermore, since the yields are derived from volume-weighted transacted prices, and/or midquotes as necessary, on term cash instruments (i.e. U.S. Treasury Bills, Notes and Bonds), the Tradeweb ICE CMT Rates could provide an attractive term risk free rate benchmark, without having to rely on the derivatives markets and associated implied pricing.”
The AXI initiative differs from IBA's Bank Yield Index in that it would incorporate data from bank funding with maturities up to five years by tapping secondary-market corporate bond price and volume data from sources such as the Finra Trade Reporting and Compliance Engine (TRACE).
The AXI paper says that the ICE Bank Yield Index would estimate one-, three- and six-month credit spreads, but U.S. banks now seek relatively little funding at those maturities. However, it adds, the data underlying the ICE index could complement longer-term bond yield spreads “so as to make a robust across-the-curve credit spread index.”
Reflecting Cost of Funds
Duffie noted that the ICE approach and Ameribor derive from actual transactions and so are more indicative of banks' funding costs and harder to manipulate than a Libor-type poll, although their liquidity may currently be insufficient. AFX says more than 1,200 banks participate on its funding exchange, and a large regional, Citizens Bank of Providence, Rhode Island, recently joined as the 200th exchange member. Daily volume is averaging $2.071 billion in 2020.
Market participants using Ameribor or another alternative to price floating-rate debt will likely want to hedge those exposures, Duffie said, but a growing swap market based on a relatively small volume of underlying transactions raises concerns about robustness.
Corporate borrowers that swapped Libor-based floating rate debt to fixed-rate will ask about a similar market for new benchmarks, Duffie said, and “if there is none, they won't be happy.”
Broughton said ServisFirst Bank has sought swaps to hedge its Ameribor-priced loans, and swap dealers remain “reluctant” to price the derivatives over anything but SOFR.
Discussions with Dealers
Brookline Bank in Massachusetts is in discussions with several dealers about hedging its broker deposits priced over Ameribor with short-term swaps in the one- to three-year range.
“We're not there yet. Swaps haven't developed,” said Reed Whitman, treasurer at Brookline, although he anticipates clarity on that issue toward year-end. He said that the lack of a swap market is one reason Brookline has yet to offer Ameribor or SOFR in a formalized manner to its customers. The bank is currently designing customer-facing loan products tied to SOFR and Ameribor and plans to begin offering them in early 2021.
Brookline was another early supporter of Ameribor. It has made use of the benchmark internally, pricing loans between the bank and its holding company. After piloting it three years ago, Brookline now uses the benchmark in settling all intercompany lending. Whitman said Brookline's borrowings over the AFX and priced to overnight Ameribor range from $50 million to $100 million daily.
The bank traded the first Ameribor bank futures contract last September and is now using that market to hedge its borrowings, said Whitman, who describes it as robust and transparent.
Menu of Benchmarks
Ameribor futures and longer-term swaps could lead to a forward-looking term rate, a key feature for many corporates forecasting cash flows. Sandor said, “We're looking into a forward looking term rate, similar to what exists now for Libor.”
AFX wants to provide a menu of Ameribor benchmarks to meet users' varying needs, including the 30-day average of overnight Ameribor in arrears that's already available and Ameribor30.
“We want to offer our members a variety of choices,” Sandor said, adding that AFX anticipates providing indicative 90-day forward Ameribor, calculated using both the new methodology and eventually also generated from futures and swaps contracts.
AFX tested macroeconomic drivers against 30-day Libor rates over the past 10 years to determine the combination of drivers that best explained the rates. The drivers included a key macroeconomic indicator and risk and risk-free rates that, incorporated into the model, explain 99.595% of the variation in 30-day Libor compared to overnight Libor.
According to AFX, the model's strong correlation with 30-day Libor should also enable it to produce a reasonable and appropriate forward-looking Ameribor30 rate.
AFX plans to publish a paper explaining the underlying components of the model in late October, pending resolution of intellectual property issues.
A term rate will enable Ameribor to better reflect credit risk. Duffie said that unsecured overnight rates such as fed funds and Ameribor tend not to react much when the market is volatile. A forward-looking term Ameribor would widen in more volatile credit environments. And, assuming a more robust underlying transaction volume, it would provide a more effective swap market to hedge risk.
“For a bank borrowing money out three or four years, a few basis points of overnight-borrower credit spread is not much,” Duffie said.
From In-Arrears to Forward-Looking
SOFR and Ameribor currently allow for in-arrears rates that calculate the average rate over the previous 30 and 90 days to estimate what the rates will be over the next 30 and 90 days. Those estimates tend to be close to compounding SOFR daily over the next 30 or 90 days, but the disparity may nevertheless be problematic for institutions managing their cash flows.
Whitman said he anticipates borrowers initially using the SOFR and Ameribor in-arrears rates and switching to the forward-looking term rate when the futures and swaps markets become robust enough to reference. In the end, he said, corporate borrowers are less concerned about how the rate is calculated, and more about the volatility of the underlying benchmark and all-in costs.
He added that the initiative to explain to corporate clients the need to replace Libor can be a daunting task, as is how SOFR is generated.
“Ameribor is a rate at which banks borrow from one another, based on an index generated in Chicago by the father of Treasury futures. That's an easy story to tell,” Whitman said.