Call it the battle of the benchmarks. As much as US authorities have been eager to persuade the financial markets to adopt the Secured Overnight Financing Rate, or SOFR – the benchmark they have slated to replace dollar-based LIBOR when it is phased out for new contracts at the end of the year – it seems plenty of market participants are not buying into it.
There is a lot riding on a smooth transition. The London Interbank Offered Rate underpins hundreds of trillions of dollars of financial instruments – predominantly derivatives – and includes an estimated $6 trillion of commercial loans. Not exactly small potatoes.
Consulting firm Oliver Wyman has estimated that a typical US bank today has 20-25 percent of its balance sheet in LIBOR. When commercial real estate and mortgages are included in the overall tally, the consultant concludes that there are nearly $10 trillion of LIBOR-referenced loans outstanding in the US.
But LIBOR, an unsecured interest rate benchmark that is published daily, is refusing to go quietly, at least in the US commercial lending market. “So far, the rate that is going away is winning,” said an Oliver Wyman presentation on the transition this summer. And that is because SOFR and LIBOR are not interchangeable.
“There’s no question that SOFR is a more transparent and more liquid underlying market than LIBOR,” says J Paul Forrester, a partner in law firm Mayer Brown’s Chicago office. “The problem is that it’s not comparable to LIBOR because it doesn’t reflect many lenders’ funding costs and is less credit-sensitive.”
LIBOR, which came into existence in the late 1960s, is based on a poll of a small number of global banks. It is calculated daily by averaging what those lenders say they would pay overnight to borrow from each other, not what they actually paid. That has left it vulnerable to manipulation.
After a scandal involving collusion by some high-profile institutions came to light in 2012, regulators in the UK decided to hand over its administration to the Intercontinental Exchange Benchmark Administration from the clubbier British Banking Association, and to replace LIBOR with something more transparent.
SOFR, which the Federal Reserve Bank of New York began publishing in April 2018, is a broad measure of the overnight cost of borrowing cash that is collateralised by US Treasuries in the so-called repo market.
The secured rate is based on approximately $1 trillion of daily transactions between a diverse set of borrowers and lenders.
“One of the concerns with LIBOR was that $1 billion of transactions in the London market was dictating the rate on hundreds of trillions of dollars of transactions,” says Roger Chari, a partner at Duane Morris who heads the law firm’s LIBOR transition team.
SONIA’s the one
In the UK, new contracts and loans based on LIBOR are well on the way to being replaced by the Sterling Overnight Index Average, or SONIA, which is based on actual trades in the UK overnight unsecured lending and borrowing market. The British benchmark is administered by the Bank of England, which publishes the rate every business day.
But the changeover has not been nearly as smooth in the US. The Alternative Reference Rates Committee, an industry panel charged by the Federal Reserve Bank of New York with leading the transition, is strongly advocating for SOFR. The rates committee “is trying to do a rate for all seasons”, says Adam Schneider, a partner in Oliver Wyman’s financial services practice who also sits on the panel, known as the ARRC. “There was a rate for all seasons, LIBOR. Replacing it with a new rate that has different characteristics is daunting.”
The main problem is that SOFR is a risk-free rate because it is based on overnight borrowing backed by US Treasuries, while LIBOR is sensitive to credit conditions. This means that if there is a market event and SOFR is the prevailing rate, the rate banks charge for loans will be likely to fall – since SOFR is risk-free and essentially a safe harbour – while their cost of funds will rise.
This is likely to lead customers to draw down their credit lines and could cause a serious mismatch between the cost of loans and the cost of bank borrowing in the market. As rates fall, borrowing from banks rises, even as it becomes more expensive and difficult for lenders to get funding.
“This is how markets behaved in past crises, and banks are wondering how to protect themselves if they lend with SOFR,” says Schneider. All the stimulus that was injected into the system because of the pandemic, among other things, helped to push rates on 10-year Treasury inflation-protected securities to a record low of minus 1.132 percent at the end of July.
“It’s perplexing to me that regulators would be endorsing SOFR as a reference rate for commercial lending,” says Harris Simmons, chairman and chief executive of Zions Bancorporation, a Utah-based lender with more than $80 billion of total assets. In times of stress, when credit spreads are widening and market participants are “piling into Treasuries and repo rates are coming down, it seems to me that you set the stage for the equivalent of driving down the freeway the wrong way during a crisis”.
Moreover, if a risk-free rate such as SOFR predominates during a crisis, “the risk is that the market’s going to freeze up and lenders aren’t going to want to be lending at the very time you need them to”, says Simmons.
Zions Bancorporation began adopting Ameribor, a credit-sensitive rate that is published on the American Financial Exchange, this summer as a substitute for LIBOR. The lender now has a number of clients with this reference rate incorporated into their loan agreements.
With LIBOR, both loans and bank funding costs move the same way during stress, creating more equilibrium. But with SOFR, the cost of money goes up and the price of loans goes down. According to Schneider: “Changing this dynamic will either mean not using SOFR – and there is pressure to use other rates – or restructuring lending products to provide banks with more protection,” with fees or significant rate floors on loans.
Many banks are moving towards more recently developed credit-sensitive rates as an alternative to LIBOR. The CSRs include Ameribor; Bloomberg’s Short Term Credit Sensitive Index, known as BSBY; and credit-inclusive term rates and spreads, known as CRITR and CRITS, that are published by IHS Markit. In addition, ICE is testing a dollar-based credit-sensitive rate.
Unsurprisingly, just a few months away from the deadline to stop using LIBOR for new instruments, many banks are still hesitant to make the transition to SOFR. “A lot of people are trying to figure out what everybody else is doing,” says Matt Hays, a partner in law firm Dechert’s global financial practice who leads the firm’s LIBOR transition taskforce. “Nobody wants to be the first mover.”
The lack of consensus on a preferred alternative is slowing down the transition.
Although there is an imminent need to move lending to new rates, “little lending is being done on any new rate”, according to Oliver Wyman. Fund prospectuses are cautioning that the uncertainty surrounding a LIBOR replacement could create more volatility. One big issuer of collateralised loan obligations tells Private Debt Investor that as recently as this summer, leveraged loans were still being priced using LIBOR.
“The market still hasn’t seen a SOFR syndicated loan,” says Chari of Duane Morris.
That is partly because the ARRC took so long to endorse a forward-looking term rate for SOFR, which is crucial to remove uncertainty about rate changes for the large number of commercial and consumer loans with floating rates. Although there are seven different tenors for LIBOR, and much of the leveraged lending market uses term rates, SOFR was largely limited to an overnight rate until this summer.
The ARRC originally said it would recommend a term SOFR rate by mid-2021, but then reversed itself. It finally endorsed a term SOFR rate published by the Chicago Mercantile Exchange, the derivatives market operator, in late July. However, Oliver Wyman says that there will not be an ability to hedge term SOFR until at least 2023. Meanwhile, all the credit-sensitive benchmarks have term options.
Jim Aronoff, a managing director in the restructuring and dispute resolution practice of accounting firm CohnReznick, says that many of his clients believe LIBOR was not broken in the first place. “As bizarre as it sounds, a comment I hear very frequently is, ‘I understand allegations of market manipulation led to concerns about LIBOR, but now that such concerns have been alleviated, can’t better controls simply be installed?’”
Although the US Federal Reserve supports the use of SOFR, chairman Jerome Powell has testified before Congress that the ARRC’s recommendations and the use of SOFR are voluntary, and that market participants should transition away from LIBOR “in the manner that is most appropriate given their specific circumstances”.
Nevertheless, Treasury Secretary Janet Yellen at a meeting of financial regulators in June urged bankers and other market participants to avoid alternative rates that she said are not robust enough to underpin many other financial products. At the same meeting, the Fed’s vice-chairman, Randal Quarles, who has strongly advocated for the use of SOFR, said “LIBOR is over”.
In a speech in June, Quarles said SOFR “rests on one of the deepest and most liquid markets in the world and is therefore likely to remain available even when other financial markets are disrupted”. According to the New York Fed’s website, “during acute market stress in March 2020, SOFR volumes remained robust – while activity in term unsecured markets further dried up”.
At roughly $1 trillion, daily SOFR trading in the repo market dwarfs the volume in both the overnight and term credit-sensitive rates. But the repo market relies heavily on trading by just a handful of banks, according to the Bank for International Settlements. By contrast, the American Financial Exchange, where Ameribor is traded, represents about 25 percent of US banks in terms of both assets and by number.
So far, there is “limited” activity in SOFR futures and derivatives, says Mark Cabana, head of US rates strategy at Bank of America. Cabana believes “there’s enough trading activity” underlying the credit-sensitive rates to inform their indices.
He expresses concerns about how credit will be priced off SOFR versus an index that has credit risk. Cabana says that although the Fed has not said so explicitly, he thinks the central bank believes there is an advantage to having a rate it can easily control, and that the banking sector would be safer using a risk-free rate.
“The Fed from day one has hated the fact that a major international rate is being set by markets over which they have no control,” says Mayer Brown’s Forrester. “It does affect their ability to implement monetary policy.” With SOFR, because the Fed can intervene in the US repo market through its open-market operations, the US central bank “can push rates around any way they want”.
The Fed in late July launched a standing repo facility to provide liquidity to big Wall Street banks and other central banks to help stabilise markets experiencing stress.
Under the facility, primary dealers could exchange Treasury and other debt with the central bank for overnight cash loans at a rate of 0.25 percent. The Fed, which set a $500 billion daily cap on the facility, first intervened in the repo market in September 2019, when “overnight money market rates spiked and exhibited significant volatility, amid a large drop in reserves due to the corporate tax date and increases in net Treasury issuance”, according to the Fed’s website.
In a briefing to the Federal Open Market Committee at its April meeting, recorded in its minutes, Fed staff noted that repo operations “have been a useful tool in controlling the federal funds rate by adding reserves to ensure that they remain ample, and by limiting pressures in repo markets that could spill over into unsecured markets”. They cited the repo operations’ role in helping to stabilise financial markets in March 2020.
However, a few participants pointed to the risk that “such a facility could crowd out private market sources of liquidity provision”.
All that aside, “widely differing views” remain on which rate to use, according to Oliver Wyman.
Law firm Katten, in its Private Credit Survey Report 2021, published in April, said that a majority of the lenders and private equity sponsors polled admitted they were not very prepared for the LIBOR transition. All the replacement language in existing documents must be changed, at a significant cost of time and money, although in the US market participants generally have until mid-2023 to replace existing LIBOR contracts with another rate.
To prevent a flood of lawsuits, New York state enacted a law last spring to designate SOFR as a fallback in LIBOR legacy contracts that either do not have one or where counterparties cannot agree. And there is a move in the US Congress to reference some form of SOFR as a fallback.
But with the end of the year fast approaching, the majority of borrowers surveyed by Oliver Wyman say they have not yet even been approached by their banks to discuss available options.
“The trillion-dollar question is, ‘What are people going to do?’’’ says Dechert’s Hays.
“We expect a real dogfight between term SOFR and various alternative rates this fall,” says Oliver Wyman’s Schneider. It is unclear if and when there will be a winner.