Unless Gensler’s statement is just bluster or subject to reconsideration, it is difficult to see how Bloomberg will be able to claim with much credibility that BSBY is IOSCO compliant.
In our last Alert, we explored some of the motivations and goals of the Alternative Reference Rates Committee of the New York Federal Reserve Bank (ARRC) and U.S. regulators in selecting SOFR as the preferred replacement rate for LIBOR. At the June 11, 2021, principals meeting of the Financial Stability Oversight Council (FSOC), these motivations and goals were on full display. The FSOC was established as part of the U.S. Department of the Treasury under the Dodd-Frank Act in the wake of the 2008 financial crisis to monitor the stability of the nation’s financial system. In their prepared remarks before the FSOC, several regulators made important statements that market participants would be well advised to consider as they navigate the ever-changing landscape of LIBOR transition.
The top line message was fairly simple: LIBOR is over and transition away from it must occur. All of the speakers offered effusive support for SOFR as a robust, reliable replacement for a wide range of markets that was developed after much effort and careful consideration by regulators. Nothing surprising there.
However, the primary topic of the remarks appeared to be the alternatives to SOFR, mostly unnamed except for one significant exception (as we will discuss below). Acting Comptroller of the Currency Michael Hsu set the general framework by stating, “We expect every bank, regardless of size, to demonstrate that its replacement rate selections are appropriate for the bank’s products, funding needs and operational capacities.” He ended by reminding that “OCC examiners will continue to work with banks to ensure their full preparedness.” These words sound fairly innocuous, but in the context of an OCC inquiry and examination, they can be anything but that.
Secretary of the Treasury Janet Yellen also kept her prepared remarks brief and general. She expressed concern that the selection of “alternative rates that lack sufficient underlying transaction volumes” may cause some of LIBOR’s shortcomings to be replicated. In particular, “the volume of derivatives contracts referencing these alternative rates could quickly outnumber the transaction volumes underlying the reference rate.”
Acting Chair Rostin Behnam of the Commodity Futures Trading Commission followed up on Yellen’s remark by pointing to U.S. Federal Reserve estimates that more than $200 trillion of U.S. dollar LIBOR derivatives are based on LIBOR transactions of about $1 billion per day, and at times below $100 million in the case of three-month LIBOR. Behnam did not mention the trading volumes of alternative rates such as Ameribor or BSBY, but it goes without saying that their volumes are substantially less than the $700 billion to over $1 trillion of daily transactions underlying SOFR.
Randal Quarles, vice chair for supervision of the Board of Governors of the Federal Reserve System, gave more specific guidance to market participants on alternative rates. As a general matter, he noted that “lenders and borrowers are free to choose the rate they wish to use to replace LIBOR.” However, he went on to caution that they should “ensure that they understand how their chosen reference rate is constructed” and make sure “they are aware of any fragilities associated with that rate and the markets that underlie it.”
After expounding upon the virtues of SOFR, Quarles continued to describe a bifurcated approach to alternative rates. For the capital markets and derivatives, Quarles noted that “the ARRC did not recommend rates other than SOFR.” For noncapital market products, he reiterated that “lenders and borrowers are free to choose among rates that meet their needs.” Nonetheless, he emphasized that SOFR, particularly Term SOFR, will “play a role in these markets as well.” Quarles then returned to the capital markets and derivatives for his parting shot, stating that “[f]inancial firms do not have the luxury to burn time reinventing the wheel on the pricing of capital markets products and derivatives when the intensive work of the private-sector experts on the ARRC has described a clear transition path.”
The thrust of these remarks suggests that the pressure is off a bit on Ameribor as an alternative rate, since it is largely a rate being adopted by middle market, regional and local banks. Gary Gensler, chair of the U.S. Securities and Exchange Commission, did not definitively rule out further comment on Ameribor, but his failure to mention Ameribor is telling. Like the other regulators, he noted the weaknesses of LIBOR and the goal of the international Financial Stability Board that “[b]enchmarks which are used extensively must be especially robust.”
While the other speakers were general in their comments, Gensler was quite specific in singling out one rate in particular for his comments—the Bloomberg Short-Term Bank Yield Index (BSBY). He pointed out that LIBOR and BSBY share a number of similarities. Both are based on unsecured bank to bank lending based on specified terms of one, three, six and 12 months. LIBOR is based on data from a panel of between 11 and 16 banks. The number of banks reporting commercial paper and certificate deposit trades for BSBY is only marginally bigger at 34. Similar to LIBOR, the trading volume supporting three-month BSBY is only in the “single-digit billions of dollars per day” per Bloomberg’s own numbers. Even the volume for the more active one-month BSBY is only in the low double-digit billions of dollars per day, and the six- and 12-month BSBY volumes are substantially lower.
In Gensler’s view, the low trading volumes supporting BSBY would provide “a heck of an economic incentive to manipulate” the rate if it were to be used in hundreds of trillions of dollars in transactions like LIBOR. He pointed out an even worse scenario: At the start of the pandemic in the spring of 2020, the commercial paper lending market “evaporated” for about five weeks. In Gensler’s colorful imagery, this lack of resiliency to market stress is “the same emperor” that had no clothes as LIBOR during the 2008 financial crisis.
Gensler then drew from his experience as the co-chair of the group under the International Organization of Securities Commissioners (IOSCO), which drafted the IOSCO Principles for Financial Benchmarks. One of the guiding principles of the group was to establish a replacement benchmark that “reflects a credible market for an interest measured by [the] Benchmark.” Gensler was quite blunt in asserting that “I don’t believe that BSBY meets that standard” or the FSB standard that it be “especially robust.” This is in direct conflict with Bloomberg’s self-certification of IOSCO compliance, as reportedly confirmed by an assurance review of “a global, independent accounting firm.”
Unless Gensler’s statement is just bluster or subject to reconsideration, it is difficult to see how Bloomberg will be able to claim with much credibility that BSBY is IOSCO compliant. This may not be a decisive factor in market adoption of BSBY, but it is one on which the market has been focused. As applied to the innocuous sounding guidance of acting OCC Comptroller Hsu above, lack of IOSCO compliance, as asserted by the SEC chair and co-chair of the IOSCO group that drafted the IOSCO principles, may make it challenging for a bank to demonstrate that the rate is “appropriate.”
What about Ameribor? Trading volumes are reportedly about the same level as underlying transactions for BSBY. The key difference is the scope of use. The phrase “non-capital markets” as used by Quarles is a synonym for the Main Street lending done by middle market, regional and community banks that comprise the backbone of the American Financial Exchange (AFX), on which Ameribor is based. Although the AFX has aspirations for Ameribor to become the replacement rate of choice among such lenders, by its nature the appeal of the rate is limited. Such lenders generally do not have access to the secured overnight repo market that supports the calculation of SOFR. If they did, SOFR would more closely match their cost of funds. These lenders serve a vital role in the communities and businesses that they serve, but they are not likely to generate hundreds of trillions of dollars of loans and derivatives.
That is the realm of the capital markets lenders that are supporting BSBY. Due to their sheer volume, the capital markets pose a risk to the stability of the financial system that is orders of magnitude greater than the Main Street lending world. A financial crisis in the capital markets is likely to have a ripple effect on the rest of the financial community. A crisis in the noncapital markets is more likely to be contained. Lenders in both the capital markets and on Main Street may not like SOFR since it does not contain a sensitivity to credit risks that fairly compensates them in times of market turmoil. However, in the context of a 2008 financial crisis, the ARRC and regulators are apparently not inclined to give capital markets lenders the leeway to “choose among rates that meet their needs” that they are willing to give to noncapital market lenders if it risks another meltdown.
As lofty as the regard that the ARRC holds for SOFR, it almost canceled Term SOFR over similar volume and scope of use concerns. Having seen the overwhelming market desire for such a forward-looking rate, it laid out key principles and market indicators that would allow it to recommend Term SOFR. As the market worked within its framework, the ARRC rewarded the market accordingly with increasingly positive and surprisingly rapid support for Term SOFR. As Quarles put it, regulators are open to market participants choosing the rates that “meet their needs.” In the case of the noncapital markets, they humbly submit that Term SOFR can also “play a role.” They are less open to the capital markets taking “the luxury to burn time reinventing the wheel” that the ARRC spent years developing.
About Duane Morris
Duane Morris attorneys assist lenders in formulating their documentation and strategy for post-LIBOR loans and applying amendments that address the interest rate changes in legacy loans through general, descriptive measures. As the end of LIBOR draws closer, Duane Morris’ LIBOR Transition Team will continue to monitor developments and issue additional Alerts. Stay tuned to the LIBOR Transition Team webpage and blog for updates.
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