Given a long wave of scandals that lasted from 2008 until 2012, most of the derivatives industry, and most of its regulators, have agreed that the London Interbank Offered rate [Libor] ought to be replaced by a more tamper-resistant mechanism.
Surely there must be an index that will measure the average of the most short-term of private loans, if only because the drive to market completeness suggests there should be derivatives founded on such an index. If that index is not to be Libor: what will it be?
Libor is a forward-looking three-month rate on private debt. The Federal Reserve favors the Secured Overnight Funding Rate (SOFR) as an alternative—though SOFR is a transaction based, and thus a backward-looking, overnight rate.
In August 2018, Barclays advanced the cause of SOFR by becoming the first bank to issue commercial paper tied to this rate.
Problems with SOFR
But dealer banks don’t like SOFR. Or, at least, they haven’t warmed to it SO FAR. (That’s a little interest-rate-nerd humor folks.) One problem with it is that at times of crisis, SOFR falls relative to the actual cost of dealer bank money, squeezing their margins.
More important, SOFR hasn’t gained general acceptance among traders. On Jan. 29, the CME one-month SOFR futures contract traded just 2,636 contracts. That is anemic: by way of comparison, the CME Eurodollar Futures Contract traded close to 3.7 million contracts that day.
Yes, SOFR contracts may be new, but if the market demanded them, the numbers would be higher. Steve Wunsch, of Wunsch Auction Associates LLC, said in a recent post in TabbFORUM that a changeover from Libor to SOFR, or anything else along the same lines, invites failure. The call market structure ”was critical to Libor’s success, its elimination will make it [an alternative] forever non-viable.”
Wunsch makes reference to the Eonia, (Euro Overnight Index Average) another effort at replacing Libor. The Eonia failed simply because no one wants to trade it. Indeed, this September the European Union abandoned it, announcing a substitute for that substitute, the Ester, which will not be available until the fourth quarter of this year at the earliest.
The problem, then, is this. Regulators won’t accept a quote-based system for indexing, because they believe that the quote-based character of Libor was the heart of the problem. Without a quote-based system, one is stuck with a backward-looking or transactional system, and the dealers and the markets have established that they don’t want that. Also, everybody does want an index of some sort and expects that derivatives on this index will be actively traded. Is there a way to get to “yes?”
The ICE Proposal
Intercontinental Exchange, on Jan. 24, promoted a possible alternative to either Libor or SOFR, which it called the US Dollar ICE Bank Yield Index. This would be based on unsecured bank debt over one-, three-, and six-month intervals. ICE is looking for responses to its idea by March 31. If the market response is positive it may launch the index as early as next year.
To quote another recent TabbFORUM piece, this one by Kurt Dew, an economist at Northeastern University, Boston, the ICE proposal is an effort to meet regulators half-way, to provide a “vague selection criteria from multiple illiquid market sources” in such a way as to make the index transactional enough for the regulators, yet forward-looking enough for the market.
As ICE itself puts the point, the idea is to “measure the average yields at which investors are willing to invest in the unsecured debt obligations of a broad set of large, internationally active banks for specified forward-looking tenors,” on the one hand, but to do this using “transaction data representing short-term, unsecured bank investment yields on the other.” A “solid transactional foundation should make the index robust,” we are assured.
Will the ICE Bank Yield Index catch on? On the one hand, since the markets collectively include wisdom not available to any of us individually, the answer is … blowing in the wind.
On the other hand, what we can know is that given the huge volume and value of Libor legacy deals, the transition from the old system to a new one—any new one—was sure to be tricky ever were there agreement on what the new one would look like. Since there plainly isn’t, and since no broad consensus is in sight, there is some significant missing infrastructure for interest-rate swaps, variable mortgages, student loans, etc. And that lacuna is going to be with us for a long time.