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Unless Gensler’s statement is just a boast or subject to reconsideration, it’s hard to see how Bloomberg will be able to claim with much credibility that BSBY is IOSCO compliant.
In our latest alert, we explored some of the motivations and goals of the Federal Reserve Bank of New York’s (ARRC) Alternative Benchmark Rates Committee and U.S. regulators in choosing SOFR as the preferred replacement rate for LIBOR. At the Directors’ Meeting of the Financial Stability Supervisory Board (FSOC) on June 11, 2021, these motivations and goals were fully exposed. The FSOC was established under the US Department of the Treasury under the Dodd-Frank Act following the 2008 financial crisis to monitor the stability of the country’s financial system. In their prepared remarks to the FSOC, several regulators made important statements that market participants would be well advised to take into account as they navigate the ever-changing landscape of LIBOR transition.
The message on the first line was pretty straightforward: LIBOR has ended and the transition must occur. All speakers offered full support to SOFR as a robust and reliable replacement for a wide range of markets that has been developed after much effort and careful consideration by regulators. Nothing surprising about that.
However, the main topic of remarks seemed to be alternatives to SOFR, mostly unnamed, with one significant exception (as we’ll see below). Acting Currency Comptroller Michael Hsu set the general framework, saying, “We expect every bank, regardless of size, to demonstrate that their replacement rate selections are right for the product, what they need. financing and operational capacities of the bank. He ended by recalling that “the OCC examiners will continue to work with the banks to ensure their full preparation”. These words sound harmless enough, but in the context of an OCC investigation and review, they can be anything but that.
Treasury Secretary Janet Yellen also kept her prepared remarks brief and general. She expressed concern that selecting “alternative rates that do not have sufficient underlying transaction volumes” could lead to the replication of some of the loopholes in LIBOR. In particular, “the volume of derivative contracts referencing these alternative rates could quickly exceed in number the volumes of transactions underlying the reference rate”.
Acting Chairman Rostin Behnam of the Commodity Futures Trading Commission followed up on Yellen’s remark by pointing out that the US Federal Reserve estimates that more than $ 200 trillion in US dollar LIBOR derivatives are based on LIBOR transactions from about $ 1 billion a day, and sometimes less than $ 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 significantly lower than the $ 700 billion to over $ 1,000 billion in daily transactions underlying the SOFR.
Randal Quarles, vice president for oversight of the Board of Governors of the Federal Reserve System, provided more specific guidance to market participants on alternative rates. Generally speaking, he noted that “lenders and borrowers are free to choose the rate they wish to use to replace LIBOR”. However, he added that they should “make sure they understand how the chosen benchmark rate is constructed” and ensure “that they are aware of any fragility associated with that rate and the markets that under- stand it. tend “.
After exposing the virtues of SOFR, Quarles went on to describe a bifurcated approach to alternative rates. For capital markets and derivatives, Quarles noted that “the ARRC has not recommended rates other than SOFR”. For non-market products, he recalled that “lenders and borrowers are free to choose from the rates that meet their needs”. Nevertheless, he stressed that SOFR, in particular Term SOFR, “will also play a role in these markets”. Quarles then returned to the capital and derivatives markets for his farewell shot, stating that “[f]Financial firms don’t have the luxury of wasting time reinventing the wheel on pricing of capital market products and derivatives as intensive work by private sector experts on the ARRC has outlined a clear transition path. “
The gist of these remarks suggests that the pressure is a bit relaxed on the Ameribor as an alternative rate, as it is largely a rate adopted by mid-market, regional and local banks. Gary Gensler, chairman of the U.S. Securities and Exchange Commission, hasn’t definitely ruled out further comments on Ameribor, but his inability to mention Ameribor is revealing. Like other regulators, he noted the weaknesses of LIBOR and the objective of the International Financial Stability Board that “[b]marks which are widely used must be particularly robust. “
While the other speakers were general in their comments, Gensler was fairly specific in targeting a particular rate 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 interbank loans on the basis of specified terms of one, three, six and 12 months. LIBOR is based on data from a panel of 11 to 16 banks. The number of banks reporting commercial paper and certificate deposit transactions for BSBY is only slightly over 34. Similar to LIBOR, the volume of transactions supporting three-month BSBY is only “billion dollars” per day ”according to Bloomberg’s own figures. . Even the most active one-month BSBY volume is only a few billion dollars a day in double digits, and six and 12 month BSBY volumes are considerably lower.
In Gensler’s view, the low trading volumes supporting BSBY would provide “a hell of an economic incentive to manipulate” the rate if it were to be used in the hundreds of billions of dollars in transactions like LIBOR. He pointed to an even worse scenario: At the onset 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 resilience to market stress is “the same emperor” who didn’t have clothes like LIBOR during the 2008 financial crisis.
Gensler then drew on his experience as co-chair of the International Organization of Securities Commissioners (IOSCO) group, which drafted the IOSCO Principles for Financial Benchmarks. One of the guiding principles of the group was to establish an alternate benchmark that “reflects a credible market for an interest measured by [the] Benchmark. Gensler was quite blunt in saying that “I don’t believe BSBY meets this standard” or the FSB standard that it is “particularly robust”. confirmed by an assurance review of “an independent global accounting firm”.
Unless Gensler’s statement is just a boast or subject to reconsideration, it’s hard to see how Bloomberg will be able to claim with much credibility that BSBY is IOSCO compliant. This may not be a deciding factor in the market uptake of BSBY, but it is a factor the market has focused on. As applied to the harmless guidance from the Acting OCC Hsu Controller above, the lack of IOSCO compliance, as stated by the Chairman of the SEC and the co-chairman of the IOSCO group who drafted IOSCO principles, can make it difficult for a bank to demonstrate that the rate is “appropriate”.
And Ameribor? The trading volumes would be roughly at the same level as the underlying trades for BSBY. The main difference is the scope of use. The term “non-capital markets” used by Quarles is a synonym for the main street loans made by the middle market, regional and community banks that form the backbone of the American Financial Exchange (AFX), on which Ameribor is based. While AFX strives for Ameribor to become the replacement rate of choice among these lenders, by its nature the attractiveness of the rate is limited. These lenders generally do not have access to the secure overnight repo market which supports the calculation of SOFR. If they did, the SOFR would more closely match their cost of funding. These lenders play a vital role in the communities and businesses they serve, but they are unlikely to generate hundreds of billions of dollars in loans and derivatives.
This is the domain of the capital markets lenders who support BSBY. Due to their sheer volume, capital markets pose a risk to the stability of the financial system that is an order of magnitude greater than that of the world of main street lending. A financial crisis in the capital markets is likely to have a ripple effect on the rest of the financial community. A crisis in non-financial markets is more likely to be contained. Lenders in capital markets and on Main Street may dislike SOFR because it does not contain a sensitivity to credit risk that fairly offsets them in times of market turmoil. However, in the context of a 2008 financial crisis, the ARRC and regulators are apparently unwilling to allow capital market lenders the latitude to “choose from among the rates that meet their needs” as they are. willing to grant to non-capital market lenders if there is a risk of a merger.
No matter how noble the consideration the ARRC gives to SOFR, it almost canceled the term SOFR for issues of similar volume and scope of use. Having seen the market’s overwhelming desire for such a forward-looking rate, he set out the key principles and market indicators that would enable him to recommend the term SOFR. As the market functioned within its framework, the ARRC rewarded the market accordingly with increasingly positive and surprisingly rapid support for Term SOFR. As Quarles said, regulators are open to market participants who choose tariffs that “meet their needs.” In the case of non-financial markets, they humbly submit that the term SOFR can also “play a role”. They are less open to capital markets by taking “the luxury of wasting time reinventing the wheel” that the ARRC has taken years to develop.
For more information
If you have any questions about this alert, please contact Roger S. Chari, Joel N. Ephross, Amelia (Amy) H. Huskins, Phuong (Michelle) Ngo, one of our banking and finance group lawyers or the lawyer of the firm with which you are in regular contact.
Disclaimer: This alert has been prepared and posted for informational purposes only and is not offered, nor should it be construed as legal advice. For more information, please see the full company disclaimer.
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