(Bloomberg Opinion) -- By now, Wall Street is well aware that its days of using the London Interbank Offered Rate are numbered. What's increasingly unclear, however, is what will rise from its ashes.
In the U.S., Libor's heir apparent was supposed to be the Secured Overnight Financing Rate, or SOFR. It began picking up momentum years ago but hasn't come anywhere close to Libor's ubiquity as banks and other market players drag their feet on transitioning away from the rate they've used for almost half a century. In 2019, the U.S. Treasury began exploring the idea of issuing SOFR-linked debt, which would be a huge step toward cementing its legitimacy as a future borrowing benchmark, yet it never moved forward; Wall Street now thinks such an offering won't happen anytime soon. Still, strategists generally expect that it will morph into a liquid derivatives and cash-market benchmark by the time dollar Libor is supposed to be retired in mid-2023.
Yet that hasn't stopped banks from generating buzz about upstart challengers that are looking to seize upon SOFR's weaknesses in a post-Libor world. The chatter suggests a real possibility that the future of short-term benchmarks won't be as simple as substituting in a single new reference rate. At the very least, three distinct rates look poised to give SOFR a run for its money.
For starters, there's the Bloomberg Short Term Bank Yield Index, known as BSBY, which launched in January and is based on actual transactions and executable quotes. (It's administered by Bloomberg Index Services Limited, a subsidiary of Bloomberg LP, the parent of Bloomberg News.) The press release said it's meant “to meet market demand for a credit sensitive index to serve as a supplement to SOFR,” though it's also available as a standalone rate. Last month, Bank of America Corp. issued the first BSBY-linked floating-rate note, something the bank's rates strategists suggested would help it gain further acceptance among borrowers given it already has “strong investor demand.” On Friday, Bank of America and JPMorgan Chase & Co. struck the first swaps trade tied to BSBY, with the other side linked to SOFR.
That breakthrough is old hat for another Libor challenger, known as Ameribor. The American Financial Exchange in December completed its first interest-rate swap linked to the alternative benchmark, which is calculated from actual borrowing costs between mostly small and midsize banks. Barclays Plc strategist Joseph Abate wrote in an April 28 report that “Ameribor and Libor are very similar,” which bolsters its pitch as an easy “plug and play” alternative. However, BSBY has similar attributes and “Ameribor seems to be somewhat noisier,” he wrote.
As if that weren't enough, Libor's administrator, the ICE Benchmark Administration, introduced its own Bank Yield Index as a potential replacement. Like BSBY and Ameribor, it incorporates banks' credit risk while SOFR doesn't. That's obvious when looking at the prevailing rates: Overnight SOFR is just 0.01% and has been pinned there since March 11, while BSBY is 0.058% and Ameribor is 0.1%. Overnight dollar Libor is currently 0.07125%.
So to recap, there's BSBY, which recently won compliance with the International Organization of Securities Commissions' Principles for Financial Benchmarks. There's Ameribor, which is also IOSCO-compliant and last week gained support from PNC Bank, which called it a “truly national benchmark.” And then there's ICE's own alternative to Libor. Meanwhile, regulators prefer SOFR because it's underpinned by some $1 trillion of daily trading, insulating it from the type of corruption that tarnished Libor. The Alternative Reference Rates Committee, a group of banks, asset managers and insurers brought together by the Federal Reserve in 2014 to oversee the Libor transition, has designated it the preferred alternative.
Yet SOFR has two glaring weaknesses. First, as previously mentioned, it doesn't capture credit risk, leaving it something closer to a risk-free rate rather than truly capturing unsecured cost of funds for banks and moving higher during times of market stress. SOFR also lacks a forward-looking term rate, which some borrowers use to manage their liquidity. The ARRC said in March that it still can't guarantee a forward-looking SOFR term rate by the end of the year.
Simply put, one of the most important shifts ever undertaken in the global financial markets remains about as much of a toss-up as ever. It says a lot that Scott O'Malia, chief executive officer of the International Swaps and Derivatives Association, claims to be “agnostic” about which dollar Libor alternative is ultimately adopted, given that more than $200 trillion of over-the-counter and exchange-traded derivatives are tied to the benchmark.
Even strategists who closely follow the twists and turns of the funding markets end up with just as many questions as answers. “As supervisory pressure on banks intensifies, which rate will they adopt: BSBY, Ameribor or SOFR, or could they use all of them but for different purposes?” pondered Abate at Barclays. “It is becoming likely that multiple rates will have a significant role in the post-Libor world,” Dan Krieter and Daniel Belton at BMO Capital Markets wrote last month, adding that there's a “very real chance” that BSBY overtakes SOFR as the primary replacement for Libor. Bank of America sees investors likely choosing to “gravitate toward a forward-looking, credit sensitive” rate instead of SOFR, given its limitations.
Maybe this is all fine, with SOFR's advantages giving it a leg up for use in floating-rate notes and derivatives, while business loans are priced using one of the credit-sensitive benchmarks. Just because Libor was all-encompassing doesn't mean that's the only way of doing things — the Bank for International Settlements acknowledged years ago that a one-size-fits-all alternative may be neither feasible nor desirable. This sort of competition emerging after a years-long effort to phase out Libor could either be seen as a last-ditch effort to get a share of the new world or an indication that weening Wall Street off of its longtime benchmark will be as difficult as ever, with no successor emerging as a clear favorite. Either way, the clock is ticking and the race is too close to call.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
©2021 Bloomberg L.P.
Essential Business Intelligence, Sharp Market Insights, Practical Personal Finance Advice, Daily Fuel, Gold and Silver Prices and Latest Stories — On NDTV Profit.
