USD LIBOR transition: credit-sensitive fallback rates

Background

The Alternative Reference Rates Committee (ARRC) and International Swaps and Derivatives Association (ISDA) have prepared form loan and hedge documentation providing for the use of the Secured Overnight Financing Rate (SOFR) as an alternative to USD LIBOR. In large part, SOFR’s proponents support the rate because it is based on a very robust market — overnight U.S. Treasury repo — as compared with LIBOR, which is an unsecured borrowing rate based on wholesale funding transactions to the extent possible, however LIBOR’s publication often relies on panel banks' expert judgment of their estimated borrowing cost. However, moving from a credit-sensitive rate to a risk-free rate (RFR) like SOFR necessitates significant changes to conventional approaches to economics and operations in debt and derivatives markets, and many market participants have expressed concerns about these changes.

Challenges with risk-free rates

Some banks have advocated for credit-sensitive alternatives because a component of their own cost of funds is tied to rates that have a dynamic credit component, which typically widens during times of market stress unlike RFRs like SOFR, which often move lower during times of stress. As a result, a bank could find itself facing a rising cost of funds while its floating rate lending rates remain static or are falling. In addition, given that SOFR is an overnight rate based on an active market, it is subject to supply and demand dynamics that can result in volatility, though the ARRC offers various compounding and averaging conventions to smooth this out.

Though the credit dynamic may be driving the push for SOFR alternatives, rates that mimic the timing and term structure of USD LIBOR are enticing for lenders and borrowers as well. In April 2021, CME began publishing a series of SOFR term rates (one-, three-, and six-month SOFR); that the ARRC formally recommended in July 2021; however, the ARRC has stated that there is a limited use case for Term SOFR derivatives (namely, for purposes of hedging end-user Term SOFR loans, as well as for regional and community banks to continue to offer “back-to-back" swap programs).

Credit-sensitive benchmarks

In recognition of these concerns, U.S. prudential regulators (Fed, FDIC, OCC) convened the Credit Sensitivity Group in February 2020. In November 2020, these regulators stated that banks may lend based on any reference rate deemed appropriate for a given bank’s funding model and customer needs; and in April 2021, following passage of New York state legislation regarding legacy LIBOR-based contracts, they urged Congress not to force institutions to adopt SOFR in any legislative solution to the tough legacy problem, thus messaging an openness to alternative rates.

In the private market, several groups have developed proprietary credit-sensitive benchmark rates as alternatives to SOFR, with ISDA modifying its definitions in early May 2021 to accommodate certain of these rates — specifically, AMERIBOR and BSBY. Certain of these rates rely on the same data underpinning LIBOR, but each with its own more nuanced methodology and attempt to create a solution that solves adoption challenges inherent in the transition from USD LIBOR, as further described below.

Other credit-sensitive benchmarks have also been either in development or proposed by certain market participants. These include:

• The ICE Bank Yield Index (BYI): published by ICE Benchmark Administration (IBA), the current LIBOR administrator, this index is designed to sit atop the implied term SOFR curve and serve as a measure of the average cost of funds for large international banks borrowing U.S. dollars for one-, three- and six-month tenors on an unsecured basis

• IHS Markit Credit Inclusive Term Rate/Spread (CRITR/CRITS): constructed by IHS Markit, a conglomerate of data providers, this standalone rate or spread designed to sit atop SOFR, as regulators’ preferred RFR, use certificates of deposit and commercial paper transactions, along with certain bond data, to reflect one-, three-, six-, and twelve-month bank borrowing costs on a senior unsecured basis

• Tradeweb/IBA constant maturity Treasury (CMT) rate: published by Tradeweb, an electronic trading network, and IBA, this tracks the volume-weighted average price of on-the-run US Treasury bills, notes, and bonds executed on Tradeweb’s dealer-to-client platform, and will include a variety of maturities ranging from one month to thirty years, effectively offering to provide a term risk free rate alternative to SOFR
• Across-the-Curve Spread Index (AXI): designed by a group of academics led by Stanford Professor Darrell Duffie, the AXI spread adjustment would measure the recent average cost of wholesale unsecured debt funding for publicly listed U.S. bank holding companies and their commercial banking subsidiaries, by taking the weighted average (by transaction and issuance volume) of credit spreads for unsecured debt instruments with maturities ranging from overnight to five years

These rates have not reached the same level of prominence as SOFR, AMERIBOR, or BSBY, nor (with the exception of CRITR/CRITS) have they certified compliance with International Organization of Securities Commissions (IOSCO) benchmark principles, but are worth monitoring, particularly if a “multiple-rate” future state comes into being. However, a growing chorus of regulators, including IOSCO, have expressed concerns around the viability of credit-sensitive rates, particularly in derivatives markets, which have seen a relatively small amount of derivatives notional traded to date.

Adoption challenges for credit-sensitive rates

These alternative rates have faced barriers in terms of broad market adoption. While for SOFR, the lack of credit sensitivity and lack of term structure have created adoption issues that have in part given rise to a world of credit-sensitive alternative rates, when it comes to those rates, liquidity will be a major gating item. Both lenders and floating-rate borrowers will demand a liquid derivatives market, which does not yet exist for AMERIBOR or BSBY, though AMERIBOR swaps have traded since December 2020, and the first BSBY swap was executed in early May 2021. Ability to designate hedges for purposes of hedge accounting will also be a driver, hinging on the FASB’s willingness to endorse any of the rates as a “benchmark” that would qualify hedges for such treatment.

More generally, it is too early to know if confidence in data underlying rates like BSBY and AMERIBOR will be sustained over time. Initial reaction to BSBY, in particular, appears to be a recognition of its robustness with concerns over the same lack of representativeness that plagued LIBOR. Finally, there is the question of what rate is better for borrowers and investors: borrowers may prefer SOFR, which does not contain a credit component and therefore is generally lower and does not spike during periods of economic stress; but lenders may not be willing to extend credit in SOFR during these times of stress. Bond investors may or may not be comfortable investing in issuances with any of the above indices, provided they’re able to invest in securities tied to them, which in turn will depend on rating agencies’ support for them.

Guidance for borrowers

Because banks have been discouraged from lending or offering hedges indexed to USD LIBOR since the end of 2021, most lenders now issue term sheets for loans indexed to alternative rates. To date, SOFR-based indices — CME Term SOFR, Daily Simple SOFR, and NY Fed 30-day average SOFR — seem to be getting the most traction. BSBY has not yet attained wide adoption; anecdotally, we’ve seen less than a handful of lenders offer to or close BSBY loans/hedges.

The post-USD LIBOR environment remains dynamic. Please reach out to the Chatham team for the latest developments on credit-sensitive fallbacks and the LIBOR transition more generally.