Financial markets are moving away from LIBOR to alternative interest rate benchmarks such as SOFR. Credit-based rates, which are currently gaining in popularity, carry greater risk than SOFR or other “risk-free rates” and should be used with extreme caution. If not, U.S. lawmakers may need to intervene to further encourage the use of safety benchmarking alternatives, writes Randy Priem.
Banks determine the interest rates at which they borrow from each other, or Interbank Offered Rates (IBORS). These benchmarks can be tied to the demand and supply of various financial products, such as deposits, Treasury bills, and commercial paper, which is a promise of short-term repayment. In recent years, despite warnings from international financial institutions, financial players have begun to adopt credit-sensitive rates (CSR). Users should use alternative “risk-free rates” whenever possible, or use only CSRs with extreme caution. If not, financial regulators may need to intervene to protect the market from CSR shortcomings and move interest rate benchmarks to safer alternatives.
Banks have been using IBOR since the late 1960s. These interest rates are set daily by a committee of banks and provide the benchmark administrator with data on the wholesale unsecured market, i.e. transactions executed by banks that are not backed by collateral (e.g. unsecured fixed deposits, commercial paper, certificates of deposit, and other short-term financial instruments). In the absence of such qualifying trades, the Panel Bank provides expert judgment based on actual trades, executed quotes, indicative quotes, or other market observations in the relevant market. The most popular of these IBORs was the London Interbank Offered Rate (LIBOR) until this year. According to the Alternative Reference Rates Committee, the amount of current contracts referencing USD LIBOR, including corporate loans, floating rate mortgages, floating rate bonds, securitized products and a wide range of derivative products, will reach nearly $200 trillion in 2020. Estimated. , roughly equivalent to 10 times the GDP of the United States.
However, in July 2017, Andrew Bailey, then chief executive of the UK Financial Regulatory Authority, said that LIBOR’s sustainability was uncertain because it was not calculated based on trades submitted by an active underlying market. expressed serious concerns. Since the global financial crisis of 2007-2009, changes in banking regulations have led to significant quantitative declines in the market size of wholesale cash deposits, commercial paper, and certificates of deposit that have historically supported IBOR, leading to a decline in IBOR. relatively inactive. . If an active underlying market is not incorporated, it is difficult to establish a benchmark that accurately reflects financial behavior, even if IBOR managers try to use transaction data in place of quotes and expert opinion whenever possible. It will be difficult. That is, if the benchmark is based on a thin market with only a small number of trades, panel banks can more easily manipulate or manipulate the market and thereby influence the resulting benchmark. More philosophically speaking, if “something doesn’t really exist”, how can it be aggregated, reflected, and available on the market? Moreover, based on only very small amounts of transactions Financial stability risks arise when benchmarks are used for contracts worth trillions of dollars (i.e., an inverted pyramid problem). As a result, the Intercontinental Exchange (ICE) Benchmark Administration, which manages many of the world’s benchmarks, has suspended all LIBOR settings by September 2024.
Even before the ICE Benchmarking Authority halted all LIBOR activity last month, a group of large U.S. private financial institutions, including the American Bankers Association and Goldman Sachs, announced that they had created alternative reference rate committees in 2014 following a rate-setting scandal at financial institutions. A society had been established. LIBOR in 2012. Several U.S. government agencies participate as ex-officio members, including the Federal Reserve and the U.S. Treasury. In 2017, the Alternative Reference Rates Committee selected the Secured Overnight Financial Rate (SOFR) to replace LIBOR. SOFR is derived from overnight government bond repurchase contracts, a type of short-term borrowing of government securities, which constitutes a more active and liquid underlying market. The abundance of trading in the overnight repo market provides a solid foundation for establishing reliable overnight risk-free rates. However, the overnight risk-free rate has a very short term and, because it is based on collateralized repurchase transactions, the default risk of the underlying overnight transaction is very small, so there is a credit risk factor such as LIBOR. is not included.
Therefore, so-called “credit sensitive rates”, such as AMERIBOR managed by AFX, have recently been developed and offered to the market as an alternative to LIBOR. These CSRs aim to measure the credit risk component of unsecured borrowings and are based on unsecured transactions with term structures like commercial paper or certificates of deposit, as opposed to alternative interest rates. CSR is therefore more similar to LIBOR in its underlying trading than to overnight risk-free rates like SOFR.
CSR may have many benefits. Interest rates are more likely to rise during periods of economic stress when credit spreads on bank debt and other wholesale borrowings widen, but overnight risk-free rates like SOFR, which do not capture credit risk, It is likely to decline as investors focus on the safety of the United States. Treasury securities. Additionally, during periods of stress, returns on banks’ SOFR-linked loans are likely to decline due to increased demand for U.S. securities, while credit spreads on bank debt and other wholesale borrowings also increase. Therefore, unhedged funding costs will rise. leading to significant asset-liability mismatches. In other words, the risk-free interest rate may not reflect banks’ marginal term funding costs, and to manage asset liability risks, financial intermediaries still rely on benchmarks that closely match these costs, i.e. risk May require a free interest rate or a term risk free interest rate. We may not be able to provide it. Therefore, interest rates that include credit factors may more accurately reflect the actual situation faced by borrowers by incorporating the cost of borrowing and the lender’s assessment of the borrower’s credit risk.
However, users should exercise extreme caution when using CSR. That is, these interest rates are often based on money market instruments such as commercial paper and certificates of deposit, and these markets are known to have been hurt by recent financial market events. In March 2020, the short-term funding market in the U.S. secondary market effectively closed, with many commercial paper, bank certificates of deposit, and municipal bonds going unbidden. Based on Financial Stability Board figures, the median number of three-month commercial paper transactions per day in the first half of 2020 was 32, worth a total of $873 million, due to the impact of COVID-19. Five deals were valued at $214 million, a decrease of 75%. -19 caused market turmoil. Indeed, as the potential impact of the coronavirus crisis became clearer, banks withdrew from short-term markets to protect capital and liquidity. Although the U.S. commercial paper and certificate of deposit markets typically operate efficiently under normal circumstances, they can become illiquid during times of stress. Due to the short-term nature of these products, investors often buy them when they are issued and hold them until maturity, resulting in lower secondary market activity. In stressful times, dealers may have little incentive to facilitate trading in these markets, in part due to tight trading margins, and may be further constrained by the cost of capital associated with holding inventory. there is.
In September 2021, the International Organization of Securities Commissions (IOSCO) issued a statement on credit-sensitive interest rates, moving to robust alternative financial benchmarks (i.e. risk-free rates) to reduce the risks posed by the suspension of monetary policy. He emphasized the importance of doing so. LIBOR and the alternatives used must comply with IOSCO’s Financial Benchmarking Principles. To ensure that benchmarks accurately reflect the economic reality they are measuring, managers must consider the size of the underlying market relative to trading volume. IOSCO expressed concern that some of LIBOR’s shortcomings were being repeated through the use of CSR without sufficient underlying trading volume. Many CSRs are based on similar data that LIBOR relied on, such as primary bank financing transactions such as commercial paper and certificates of deposit. In 2023, IOSCO published a report confirming concerns that the use of certain credit-sensitive rates could threaten market integrity and financial stability. IOSCO also asked the Administrator, its auditors and/or independent consultants to refrain from making representations that the interest rates on the credit comply with the IOSCO Benchmark Standards.
IOSCO has no legal authority to make CSR illegal and cannot prohibit its use. Unlike Europe, the United States does not have benchmark regulations that require benchmarks to meet specific representativeness and robustness standards. This means that US regulators do not have the power to stop the use of these alternative benchmarks. So, ultimately, U.S. lenders and borrowers are free to choose the interest rates they use on new loans.
Given that SOFR is based on an active underlying market, financial institutions should prioritize SOFR whenever possible. However, since overnight collateral benchmarks do not capture credit risk, users may be more inclined to choose CSR because it is not illegal. However, it is important that these users fully understand what CSR benchmarks entail, how they are constructed, and the potential vulnerabilities associated with them and their underlying markets. Users should fully understand these risks and exercise extreme caution when using them. If prudence is exercised and CSR is maintained as a benchmark next to SOFR and similar risk-free benchmarks based on active underlying markets, risks to financial markets may remain limited. However, if U.S. regulators decide that CSR will become the norm, Congress could step in and implement requirements similar to the European Benchmarking Regulation, i.e., banks can only use representative, robust and reliable benchmarks based on active markets. You should consider whether you can use , should be legalized.
Author Disclosure: The author is Coordinator of the Markets and Post-Trading Department at the Belgian Financial Services and Markets Authority (FSMA) and Professor of Finance at UBI Business School (Middlesex University, London) and Antwerp Management School. The views expressed in this article are those of the author and do not necessarily reflect the views of FSMA or any other institution with which the author is affiliated. The authors have no other conflicts of interest to disclose. Read ProMarket’s disclosure policy here.
Articles represent the opinions of the authors and do not necessarily represent the opinions of the University of Chicago, the Booth School of Business, or their faculty.
