The financial market has moved from LIBOR to alternative interest-rate benchmarks, such as SOFR. Credit-sensitive rates, which are now becoming increasingly popular, carry greater risks than SOFR and other “risk-free rates” and must be used with great care. If not, United States legislators might need to step in to further stimulate the use of safter benchmark alternatives, writes Randy Priem.
Banks determine the interest rates, or interbank offered rates (IBORS), by which they borrow from one another. These benchmarks can be tethered to the demand and supply of different financial instruments, such as deposits, United States treasury bills, or commercial papers, which are short-term promises of repayment. In recent years, financial players have started to adopt credit-sensitive rates (CSRs), despite warnings from international finance organizations. Users should stick to alternative “risk-free rates” as much as possible or only use CSRs with great caution. If not, financial regulators might need to step in to protect markets against the shortcomings of CSRs and shift interest benchmarks to safer alternatives.
Banks have used IBORs since the late 1960s. These rates are set daily by a panel of banks, which provide the administrator of the benchmarks with data on transactions executed by them in the wholesale unsecured market, i.e. not secured by collateral (e.g. unsecured term deposits, commercial paper, certificates of deposits, and other short-term instruments). If no such eligible transactions are made, panels banks provide expert judgements based on real transactions in related markets, committed quotes, indicative quotes, or other market observations. The most popular of these IBORs was, until this year, the London Interbank Offered Rate (LIBOR). According to the Alternative Reference Rate Committee, it was estimated that the current outstanding contracts referencing USD LIBOR, including corporate loans, adjustable-rate mortgages, floating rate notes, securitized products and a wide range of derivative products, amounted to nearly $200 trillion in 2020, roughly equivalent to 10 times U.S. GDP.
However, in July 2017, Andrew Bailey, at the time chief executive officer of the United Kingdom’s financial regulator, raised serious concerns about LIBOR’s sustainability because it was not calculated based on submitted transactions from an active underlying market . Since the global financial crisis of 2007-2009, changes in bank regulation have led to a dramatic quantitative reduction in the volume of markets for wholesale funding deposits, commercial paper, and certificates of deposits, which have historically underpinned the IBORs, rendering them relatively inactive. If there is no incorporation of an active underlying market, it becomes challenging to establish a benchmark that accurately reflects financial movements, even if the IBOR administrator tries to use transaction data as much as possible instead of quotes or expert opinions. That is, in the case that a benchmark is based on a thin market with only a few transactions, panel banks can more easily steer or manipulate them, thereby influencing the resulting benchmark. Even more philosophically, if “something does not really exist,” how can it then be aggregated, reflected, and used by the market? Furthermore, there are financial stability risks if a benchmark is used in contracts worth trillions of dollars while only based on a very low volume of transactions (i.e. an inverse pyramid problem). As a consequence, the InterContinental Exchange (ICE) Benchmark Administration, which administers many of the world’s benchmarks, ceased all LIBOR settings by September 2024.
Even before the ICE Benchmark Administration suspended all LIBOR activity last month, a group of private-sector financial giants in the U.S., including the American Bankers Association and Goldman Sachs, had formed in 2014 the Alternative Reference Rates Committee after a rate-setting scandal at LIBOR in 2012. Several U.S. government entities, including the Federal Reserve and U.S. Treasury, participate as ex officio members. In 2017, the Alternative Reference Rates Committee selected the Secured Overnight Finance Rate (SOFR) to replace LIBOR. The SOFR is derived from overnight treasury repurchase agreements, which are a type of short-terms borrowing of government securities and comprise a much more active and liquid underlying market. The abundance of transactions in the overnight repo market provides a solid basis for establishing a reliable overnight risk-free rate. Yet, overnight risk-free rates do not contain a credit risk component, like LIBOR did, due to their very short term and the fact that they are based on secured repurchase agreements making the default risk of the underlying overnight transactions very small.
Therefore, so-called “credit-sensitive rates,” like AMERIBOR administered by AFX, were recently developed and offered to the market as alternatives to LIBOR. These CSRs seek to measure the credit risk component of unsecured borrowings, and in contrast with alternative rates are based on unsecured transactions, often with a term structure, like commercial paper and certificates of deposits. CSRs are thus more similar to LIBOR in terms of the transactions on which they are based than the overnight risk-free rates, like SOFR.
CSRs may have many benefits. They are more likely to rise during times of economic stress when credit spreads on bank debt and other wholesale borrowings increase, whereas overnight risk-free rates like SOFR that do not capture credit risk are more likely to decline as investors turn to the safety of U.S. treasury securities. Additionally, during stressful periods, the return on banks’ SOFR-linked loans is likely to fall due to the increase in demand for U.S. securities, while their unhedged funding costs would rise because credit spreads on bank debt and other wholesale borrowing increasing as well, leading to a significant asset-liability mismatch. In other words, risk-free rates may not reflect banks’ marginal term funding costs, and to manage asset-liability risk, financial intermediaries may still need benchmarks that closely align with these costs—something risk-free rates or term risk-free rates may not provide. Rates with a credit component, by incorporating the cost of borrowing and the lender’s assessment of the borrower’s credit risk, might thus offer a more accurate reflection of the actual conditions faced by borrowers.
Yet, users should use CSRs with great caution. That is, these rates are often based on short-term money market instruments, like commercial paper and certificates of deposit, and these markets are known to have suffered from the latest financial market events. In March 2020, the short-term funding market essentially closed down without any bids in the secondary market in the U.S. for much of the commercial paper, bank certificates of deposits, or municipal debt. Based on figures from the Financial Stability Board, there was a median of 32 3-month commercial paper transactions per day in the first half of 2020 worth a total of $873 million, which plunged by 75% to five trades worth $214 million in the COVID-19 induced market turmoil. Indeed, as the potential impact of the COVID-19 crisis became clearer, banks withdrew from the short-term market to protect their capital and liquidity. The U.S. commercial paper and certificates of deposit markets typically operate efficiently under normal conditions but may be vulnerable to illiquidity during periods of stress. Due to the short-term nature of these instruments, investors often purchase them at issuance and hold them until maturity, resulting in low secondary market activity. During stressful times, dealers may have little incentive to facilitate trading in these markets, partly because of the narrow trading margins, which can be further constrained by the capital costs associated with holding inventory.
In September 2021, the International Organization of Securities Commissions (IOSCO) published a statement on credit-sensitive rates in which it stressed the importance of transitioning to robust alternative financial benchmarks (i.e. risk-free rates) to mitigate the risk arising from the cessation of LIBOR and that the used alternatives should be compliant with the IOSCO Principles on Financial Benchmarks. To ensure that a benchmark accurately reflects the economic realities it aims to measure, administrators must consider the size of the underlying market relative to trading volumes. IOSCO expressed concern that some of LIBOR’s shortcomings are being repeated with the use of CSRs that lack sufficient underlying transaction volumes. Many CSRs are based on similar data that LIBOR relied on, such as primary bank funding transactions like commercial paper and certificates of deposit. In 2023, IOSCO published a report confirming their concerns that the use of certain credit sensitive rates may threaten market integrity and financial stability. IOSCO also called on administrators, their auditors, and/or independent consultants to refrain from any representation that credit-sensitive rates were compliant with the IOSCO benchmark standard.
IOSCO lacks the legal authority to make CSRs illegal and cannot ban their use. Unlike Europe, the U.S. does not have benchmark regulations requiring benchmarks to meet specific representativity and robustness standards, meaning also U.S. regulators do not have the power to stop the use of these alternative benchmarks. Ultimately, lenders and borrowers in the U.S. are thus free to choose the rates they use for new loans.
Given that SOFR is based on an active underlying market, financial institutions should prefer it as much as possible. Yet, because overnight secured benchmarks do not capture credit risk, users may be inclined to opt for CSRs, also because they are not illegal. However, it is crucial that these users fully understand what these CSR benchmarks entail, how they are constructed, and the potential vulnerabilities associated with them and their underlying markets. Users should ensure they are well-informed about these risks and exercise great caution in their use. If caution is practiced and CSRs remain as a benchmark second to SOFR and similar risk-free benchmarks based on active underlying markets, then risk to financial markets may remain limited. However, if U.S. regulators see that CSRs become the norm, Congress should step in and consider whether a similar requirement as the European Benchmark Regulation, namely that banks can only use benchmarks that are representative, robust, and reliable thereby being based on an active market, should be made law.
Author Disclosure: The author is the coordinator of the markets and post-trading unit at the Belgian Financial Services and Markets Authority (FSMA), and a finance professor for UBI Business School (Middlesex University London), and Antwerp Management School. Views expressed in this article are those of the author and do not necessarily reflect the views of the FSMA or any other institution with which the author is affiliated. The author has no other conflicts of interest to disclose. Please read ProMarket’s disclosure policy here.
Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.
