Libor Replacements Multiply in Shift That Could Fracture Markets

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A slew of newer and lesser known reference rates are staking their claim to a share of the post-Libor landscape as the outlook for the space grows increasingly fractured.

Once largely considered afterthoughts in the race to replace the London interbank offered rate, a clutch of upstart challengers, from Ameribor and BSBY to ICE’s Bank Yield Index, have been gaining traction, or at least garnering more attention, in recent weeks. Their ascent comes as borrowers and bankers increasingly question whether the Federal Reserve’s long-preferred replacement, the Secured Overnight Financing Rate, is the best option for the multitude of markets that must ditch scandal-tainted Libor by year-end.

At the heart of the matter are two shortcomings that have long dogged SOFR: a lack of a forward-looking curve, and the absence of a credit component -- both key features of Libor that the newer rates all offer. Wall Street, for its part, has already begun signaling some support for the lesser-known alternatives. But while multiple rates could help meet the needs of various business lines, they also risk making a complex transition even more difficult, while potentially slowing the build up of liquidity in any one benchmark.

“While there was a big push to try and have SOFR be the monolith, the market seems to have other views of the type of benchmark it would like to have for very specific transactions,” said Mark Cabana, head of U.S. interest-rate strategy at Bank of America Corp. “Will SOFR end up being the key lending rate in the future? I don’t know. I think there are real questions around that.”

Libor Replacements Multiply in Shift That Could Fracture Markets

Nowhere is the race to succeed Libor more up in the air than in the multitrillion-dollar syndicated lending markets.

Almost half of respondents in a TD Securities survey published May 14 singled out loans when asked where they expect to see the greatest adoption of so-called credit-sensitive rates, with another 19% choosing all cash products and a further 22% selecting both cash and derivatives markets.

One of the main issues hindering the widespread adoption of SOFR continues to be the lack of a forward-looking term structure, according to Meredith Coffey, executive vice president of research & public policy at the Loan Syndications and Trading Association.

Yet the situation is more complex than a single obstacle. Borrowers, lenders and investors all have different needs that may be better met by different rates, said Coffey, who is also a member of the Alternative Reference Rates Committee, the Fed-backed group guiding the Libor transition in the U.S.

Banks that are offering revolving credit facilities, for example, are exposed to funding risk, and may therefore be more inclined to do a transaction based on a credit-sensitive rate, while certain borrowers may prefer SOFR, especially once a forward-looking term rate backed by robust derivatives trading can be established.

“The key thing is we’re going to be in a multirate environment,” Coffey said. “We’ve seen it. We’ve expected it. And it’s not a tragedy.”

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Just last week, Duluth Holdings Inc. became the first nonfinancial company to get a corporate syndicated loan tied to the Bloomberg Short Term Bank Yield Index, following the first swaps trade and first bank bond linked to the benchmark in April.

CME Group Inc., which launched SOFR futures more than three years ago, said Monday it plans to introduce futures based on BSBY sometime in the third quarter, with over-the-counter swap clearing to debut in the fourth quarter, pending regulatory review. CBOE Futures Exchange launched Ameribor futures in August 2019.

BSBY is administered by Bloomberg Index Services Limited, a subsidiary of Bloomberg LP, the parent of Bloomberg News.

“We appreciated it had a very high correlation to Libor and we could set some term portions on it, which under the SOFR arrangement it was going to be a little more complicated,” Duluth Chief Financial Officer Dave Loretta said in an interview.

Last month the LSTA included Ameribor, overseen by the American Financial Exchange, as a fallback option for its suggested contract provisions meant to help loans shift to alternative rates when Libor is discontinued.

The Bank Yield Index, for its part, has yet to launch, but like BSBY and Ameribor will be forward looking and credit focused. It’s overseen by the ICE Benchmark Administration, the same company that currently oversees Libor.

Liquidity Concerns

Still, not everyone is convinced more options are a good thing.

“We are concerned that it may fragment markets or decrease derivatives market liquidity,” TD Securities’ Priya Misra wrote in a recent note to clients. In a separate report she said that “it is unclear how any credit-sensitive rate would behave in a credit event.”

Bank of England Governor Andrew Bailey was more emphatic earlier this month, saying at an ARRC-hosted symposium that a myriad of credit-sensitive alternatives is not a viable option.

“While these rates may offer convenience as a short-term substitution, they present a range of complex longer-term risks,” Bailey said during a panel with Federal Reserve Bank of New York President John Williams. “While they may remove the reliance on expert judgment, they veneer over the fundamental challenges of thin and incomplete markets through the extrapolation of data.”

The ARRC encourages everyone to understand the benchmarks they choose as alternatives to Libor so that they can avoid having to go through a costly and risky transition again, Tom Wipf, chair of the group, said via email. He added that SOFR is a robust rate that will meet many of the needs of market participants.

Ultimately, few are arguing that SOFR won’t play an important role in the post-Libor landscape over the next few years, and many still see it as the likely go-to benchmark for most types of transactions going forward.

Pension funds will use it to hedge interest-rate risk, while mortgage lenders will use it to hedge prepayment risk. So too will those who want to make a wager on the direction of U.S. monetary policy.

In fact, 60% of respondents in the TD survey said they expect the derivatives market to mostly lean on some iteration of the rate as it transitions away from Libor.

Others aren’t so sure.

“What will the dominant rate be in five or 10 years from now? That’s where I have more doubts about SOFR because of the markets’ tepid adoption of it today,” said Bank of America’s Cabana. “There’s still another chapter of the Libor transition that has yet to be written and that will involve credit-sensitive rates.”

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