As the 2021 deadline for replacing LIBOR approaches, the conversation among policy makers and market participants has shifted from which single benchmark will replace the scandal-ridden LIBOR to the value of multiple alternative benchmarks tailored to specific requirements. Regulators and capital markets participants are recognizing that borrowers and lenders need and will benefit from interest rate benchmark choice. Let’s take a step back and look at how we got here and who will benefit.
The Market Speaks
In the early days of preparing for the transition, banks and regulators focused on the idea of one single interest rate benchmark to replace the long-standing LIBOR. They pointed specifically to SOFR, the Secured Overnight Financing Rate published by the U.S. Federal Reserve.
In February, ten regional American banks wrote to bank regulators — including Federal Reserve Vice Chairman Randal Quarles, Comptroller of the Currency Joseph Otting and Federal Deposit Insurance Corp. Chair Jelena McWilliams — stating that the SOFR doesn’t work well for them. Unlike the money center banks, these regional banks don’t tend to borrow on an unsecured basis. Tying their unsecured loans to a secured rate would have the potential to create an asset liability mismatch that could heighten risk during a credit crunch.
Bank regulators listened to these concerns. In a hearing before Congress, Federal Reserve Chairman Jerome Powell explicitly rejected the idea of a congressional mandate making SOFR the only acceptable interest rate benchmark, explaining that the Fed is “working with regional [banks] and some of the larger banks, too, about the idea of also having a credit sensitive rate.”
Current Landscape Of Interest Rate Benchmarks
When it comes to alternative rates, choice is critical. It enables participants to pick the appropriate rate for their circumstances and helps lower systemic risk critical in times of crisis such as the credit crunch of the pandemic.
We now have multiple rates to better serve specific segments of the market. These LIBOR replacements are based on actual trades. They are better suited to the specific market segments they track. Internationally, the United Kingdom UK has Sonia and the eurozone has €STR — both based on unsecured overnight lending markets.
In the US, there is the Federal Reserve’s SOFR, which is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. SOFR is suitable for large financial institutions that also trade in those securities.
Many of America’s regional, mid-sized and community banks use AMERIBOR®, an unsecured interest rate benchmark, for their borrowing and lending needs AMERIBOR® tracks a volume-weighted average of unsecured overnight loans transacted. It reflects lending and borrowing activity among banks and a broad range of other capital market participants, including insurance companies, private equity firms, asset managers and corporations.
As we approach the LIBOR transition, innovations continue. Market players are currently developing replacements for LIBOR’s forward rates, including a 30-day forward rate and additional interest rate sensitive benchmarks. There are futures contracts currently traded which will provide greater transparency and price discovery.
Capital Market Participants and Consumers will Benefit
We have every reason to believe that the U.S. financial sector, the most developed, flexible and innovative in the world, will maintain an orderly and smooth transition to new interest rate benchmarks.
I urge all capital market participants to take the long view and embrace LIBOR alternatives using whichever benchmark is best suited to their requirements. Regulators, too, should resist the temptation to replace one monolithic benchmark, LIBOR, with another single benchmark. We’ve learned a good deal in these years leading up to the replacement of LIBOR, and one of the things we’ve learned is that markets thrive when participants can choose the benchmark that fits their needs most closely. Innovation will continue as institutions evolve and compete to capture market share, and both borrowers and lenders will benefit—lenders from a more accurate gauge of the risk and liquidity characteristics of their slice of the lending market and borrowers from enhanced liquidity, transparency and borrowing costs that fairly represent market conditions.
Market economists rarely agree on much, but they generally agree that diversity and choice are good for market strength and durability. Let benchmarks proliferate. We’ll all be better off.
About the Author
Dr. Richard L. Sandor is the Aaron Director Lecturer in Law and Economics
at the University of Chicago Law School. He is also chair and CEO of the American Financial Exchange, ameribor.net, an electronic exchange for direct interbank/financial institution lending and borrowing. @the AFX