personal views of a former fed trader

The Right LIBOR Successor Emerges

SOFR has long been the anointed successor to LIBOR, but it just hasn’t been very successful despite a maximum pressure campaign from the official sector. GSEs issued a lot of SOFR linked debt, SOFR futures launched, clearing houses transitioned to SOFR discounting, and New York State passed legislation to automatically move legacy LIBOR contracts to SOFR. Yet, LIBOR exposure has grown from $199t in 2016 to $223t today. Amidst the on-going transition, Bloomberg launched its own LIBOR replacement to immediate market support. Although SOFR is great for market transparency, it is ultimately something that the market did not need and cannot use as a LIBOR replacement. In this post we review the official sector’s motivation for dropping LIBOR, highlight the fatal flaws of SOFR and the explain why the Bloomberg Short-Term Bank Yield Index (“BSBY”) is a better LIBOR replacement.

The Flaws of LIBOR

LIBOR was intended to reflect the interest rates big banks paid in unsecured money markets. Big banks each submitted what they believed their borrowing rates were, and those submissions were averaged to arrive at LIBOR. In 2012 it was discovered that some banks low-balled their submissions during the Financial Crisis to bias LIBOR fixings lower, which made their bank appeared more credit worthy (and may have benefitted their derivatives positions). With this experience in mind, and noting that actual unsecured money market activity by big banks was declining, the official sector decided in 2017 to transition away from LIBOR.

Most LIBOR submissions are essentially guesses based on market data

The fundamental issue with LIBOR was that there were no longer enough daily cash market transactions to generate a robust reference rate. The Post-Crisis Basel III framework effectively discouraged banks from borrowing in unsecured money markets. Banks often did not have actual transactions to reference for their LIBOR submissions, so they just submitted guesses based on what their traders saw in the market. This reliance on ‘expert judgement’ created room for potential manipulation in the process. Regulators were not comfortable with that risk and wanted a reference rate based on actual transactions. They created SOFR.

SOFR Cannot Replace LIBOR

SOFR is an index meant to reflect overnight Treasury repo rates. Treasury repo are loans made against Treasury collateral, so they are essentially credit risk free. SOFR is based on a robust $900b in actual daily transactions, but suffers from a serious flaw – it does not contain a credit component. [Many also note that SOFR is not forward looking, but there is a plan to eventually build a forward looking SOFR based on SOFR derivatives.]

During the March 2020 panic, LIBOR as a spread to OIS (Fed policy proxy) increased to reflect deteriorating financial conditions while SOFR dropped like a rock as investors rushed into the safety of Treasury repo. The increase in LIBOR reflected increased compensation to lenders for heightened credit risk. If you lent to anyone based on SOFR you would not have received any compensation for the soaring systemic risk (you actually received less, as a spread to OIS). This is obviously unacceptable to most lenders and renders SOFR unusable as a LIBOR replacement.

In March 2020 LIBOR rose in response to stress, while SOFR declined

In addition, the current structure of the market suggests SOFR will essentially be stuck at the ON RRP offering rate for the foreseeable future. It’s fluctuations will largely be due to adjustments to the ON RRP/IOR, which in recent years has hinged upon the idiosyncrasies of the zombie Fed Funds market rather than any real changes in financial conditions. Changes in SOFR would thus be arbitrary and unpredictable.

BSBY Is a Better LIBOR

BSBY is an index constructed by Bloomberg based on actual trades and executable quotes of short-term unsecured debt transactions by a group of big banks over a 3 day rolling window (see white paper). The use of executable quotes (which are assigned lower weights than actual transactions) and a 3 day window boosts the volumes available for calculation. In addition, outliers are trimmed and the influence of any individual bank issuer is capped. BSBY is derived from fitting a curve onto this data.

BSBY uses transactions over a 3 day window Source: BSBY white paper

In practice, BSBY has closely tracked LIBOR but at a slightly lower level. Bloomberg suggests this is because the credit quality of BSBY panel banks (GSIBs + LIBOR panel banks – state owned banks) is higher than LIBOR panel banks. BSBY is essentially a robust, transaction based version of LIBOR that is calculated by a non-bank data provider. It meets the market’s needs for a credit sensitive rate and addresses the official sector’s concerns on potential manipulation.

3M BSBY closely tracks 3M LIBOR. BSBY is lower as the credit profile of panel banks is higher

SOFR provided much needed transparency in Treasury repo, one of the foundational markets in the dollar system. But it isn’t a LIBOR replacement. The official sector is adamant that everyone must move away from LIBOR, but it is not forcing everyone to use SOFR. There is room for both BSBY and SOFR – the market will ultimately decide.

3 Comments

  1. Yogi

    Excellent writing! Super helpful in understanding the dynamics in the market

  2. John Bishop

    Risk Free Rates (RFR) such as SOFR will always be more expensive than Credit Sensitive Rates (CSR) such as BSBY (or ICE BYI).
    For any doubters here, just consider supply (lenders) and demand (borrowers). RFR will have higher demand but lower supply (and CSR conversely will have lower demand but higher supply)… and so the price for RFR loans will always be higher than for CSR.
    Liquid markets in the basis between RFRs and CSR can reduce this but the way regulators are acting at the moment seems to suggest they are not looking to promote such an ecosystem.. and so they are actively creating an environment of higher cost loans to end users.
    Time for a rethink perhaps…

    • Peter

      What? Surely RFRs will always be lower than CSRs, considering the latter includes risk of default?

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