FLASH FRIDAY is a weekly content series looking at the past, present and future of capital markets trading and technology. FLASH FRIDAY is sponsored by Instinet, a Nomura company.
With the cessation of LIBOR and the market’s transition to the secured overnight financing rate, SOFR, some banks have expressed a need for credit-sensitive alternatives, according to Chatham Financial.
“A bank could find itself facing a rising cost of funds while its floating rate lending rates remain static or are falling. In addition, given that SOFR is an overnight rate based on an active market, it is subject to supply and demand dynamics that can result in volatility, though the ARRC offers various compounding and averaging conventions to smooth this out,” the firm said.
To address the needs of the market, several groups have developed proprietary credit-sensitive benchmark rates as alternatives to SOFR, including the Bloomberg Short Term Bank Yield Index (BSBY) and AMERIBOR, a credit-sensitive benchmark interest rate powered by observable transactions executed on the American Financial Exchange (AFX).
John Shay, CEO, AFX, said: “SOFR represents a great start, but the US capital markets are not a one-size-fits-all marketplace – they are highly complex.”
According to Shay, AFX believes that competition breeds more precise offerings for the varied financial markets that exist within the US economy.
“Our goal is to co-exist as a viable credit-sensitive rate alongside SOFR with a deep and robust derivatives market from which all participants can properly hedge their risk positions,” he said.
AFX sees the market evolving and crucial choices being made now that LIBOR’s official cessation is finally here.
“If you’re a bank dealer, having another index just expands your ability to diversify your own book,” he added.
“It is a great interest for the investment banks to have optionality around what types of indexes they can trade,” he added.
According to Chatham Financial, a growing number of regulators, including the International Organization of Securities Commissions (IOSCO), have expressed concerns around the viability of credit-sensitive rates, particularly in derivatives markets.
Shay argued: ”Regulators needed to make certain that a return to a submission rate and the ability to impact that rate were removed. The answer – “let’s use a pool of risk-free collateral that makes that manipulation impossible.” The downside: it leaves out countless banks who require, and frankly expect, a choice. That’s where we fit in.”
Meanwhile, on July 3, IOSCO concluded its Review of Alternatives to USD LIBOR, which assessed the extent to which four benchmarks developed as potential substitutes for USD LIBOR – two credit sensitive rates (CSRs) and two Term SOFR rates – have implemented IOSCO’s 2013 Principles for Financial Benchmarks (IOSCO Principles).
“Most significantly, the review confirmed regulatory authorities’ concerns that certain CSRs currently in use exhibit some of the same inherent ‘inverted pyramid’ weaknesses as LIBOR,” IOSCO said.
Some of the issues included “liquidity risks in the bank-issued commercial paper (CP) and certificates of deposit (CD) market data, they are not sufficiently deep, robust and reliable to underpin alternatives to USD LIBOR.”
In addition, IOSCO said: “Further, gaps in data and volatility related to reliance on a very small number of transactions mean that USD LIBOR alternatives based on these markets are unlikely to sufficiently implement the IOSCO’s Principles relating to benchmark design.”
“Low transaction volumes, coupled with the use of quotations, could not only cause deviation from rates that might be available to participants in the markets if they chose to transact, but can also increase the risk of benchmark manipulation,” IOSCO added.
In turn, AFX has issued the following response: “IOSCO has designed their benchmark principles in a way that leaves them open to interpretation by the firms seeking compliance. In particular, the benchmarks do not present specific, measurable standards that provide a minimum threshold or ratio from which to seek compliance.”
Shay added that AFX is working diligently to address IOSCO’s concerns, adding: “The industry’s evaluation of the IOSCO principles and firm compliance with them must consider the fact that the market for CSRs is in the earliest phase of implementation and market acceptance.”
