Alternatives to SOFR: an overview of existing credit sensitive rates

Introduction

On March 5, 2021, ICE Benchmark Administration (the “IBA”), the administrator of the London Inter-bank Offered Rate (“LIBOR”), announced in relation to USD LIBOR that it would cease publishing its 1-week and 2-month tenors on December 31, 2021, and all other tenors on June 30, 2023. For many in the market, this now feels like old news, but, notwithstanding the work of the Alternative Reference Rates Committee (the “ARRC”), the question of which rate will ultimately replace USD LIBOR is still very much unsettled.

In 2014, the Federal Reserve Board and the New York Fed created the ARRC to address risks related to LIBOR and tasked them with, among other things, identifying risk-free alternative reference rates for LIBOR. Subsequently, the ARRC selected the Secured Overnight Financing Rate (“SOFR”) as the recommended alternative reference rate and the CME Group (“CME”) as the administrator of SOFR. However, multiple challenges remain with the selection and implementation of SOFR as LIBOR’s replacement. 

First, LIBOR provides a forward-looking term rate. It is published daily in five currencies and for seven tenors in respect of each currency. Since 2019, it has used a “Waterfall Methodology”, whereby eligible transactions closed closest to the reporting deadline are given a higher rating, behind which comes transaction-based data including time weighted historical, eligible transactions that are adjusted for market movements, and finally expert judgment of the reference banks making up the USD LIBOR panel determined pursuant to their approved procedures. In contrast, SOFR, as recommended by the ARRC, is currently available as only an overnight rate and the ARRC has not yet recommended a forward-looking term SOFR rate, although notably, the CME, again, the ARRC appointed administrator of SOFR, currently publishes a term SOFR. Instead, the “in advance” SOFR rate that the ARRC recommends for users that need a forward-looking rate known at the beginning of an interest period simply uses past data to determine future rates.

Second, SOFR is a secured, risk-free rate, while LIBOR is an unsecured rate with inherent credit sensitivity. Consequently, SOFR is (or is expected to be), on average, lower than LIBOR. This difference begets the need for a credit spread adjustment to bridge the gap between SOFR and LIBOR. The ARRC’s procedures employ a static spread adjustment that was published by Bloomberg on March 5, 2021, and some have argued for a more dynamic spread adjustment calculated periodically to reflect variation in the LIBOR-SOFR differential.

Third, SOFR, being a backward-looking, overnight rate appears more volatile and subject to cyclic peaks resulting from several factors, including asset management practices often used in the market. This overnight volatility resulted in the need to smooth out the raw SOFR number for use in commercial products, giving rise to the various, somewhat complicated calculations in the market today (i.e., SOFR lookback with/without observation shift, compounded in arrears, compounded in advance, daily simple SOFR). So, while SOFR is far and away the most robust rate in terms of the volume of transactions on which it is based, reported by the Fed to be around $1 trillion in daily volumes (albeit limited in the variety of those transactions), standing alone, it is not a seamless replacement for LIBOR and thus it presents operational challenges in its implementation. 

In response to these concerns, particularly the lack of credit risk, various organizations, including Bloomberg, IHS Markit Benchmark Administration Ltd. (“IHS Markit”), Intercontinental Exchange (“ICE”), and American Financial Exchange, LLC (“AFX”), have or are in the process of developing alternative, credit sensitive rates (“CSRs”) that are being presented as alternatives to SOFR. Arguments for their use can be persuasive to end users -- supporters of CSRs say that use of certain of these rates better reflect a lender’s cost of funds and thus can make more liquidity available at lower costs. 

But, while the CSRs have drawn the market’s attention and are being recommended in certain sectors of the commercial loan and other markets, they are meeting with headwinds, particularly from the regulatory or governmental sector. Recent comments by Treasury Secretary, Janet Yellen, US Securities and Exchange Commission chair, Gary Gensler and President and CEO of the Federal Reserve Bank, John Williams, have warned that because of a less robust transactional basis on which they are calculated and their credit-sensitive nature, the use of CSRs may create long term risks and could even steer the industry towards the need for another benchmark replacement exercise. The CSRs have drawn attention from international regulators as well, so their use in multijurisdictional transactions is in question.

To help unpack the basics of several of today’s CSRs, subsequent pages and the chart below, while not comprehensive, aim to highlight certain key differences between LIBOR, SOFR and several of the most common CSRs that are available or are in development today.

Credit Inclusive Term Rate (“CRITR”) and Credit Inclusive Term Spread (“CRITS”)

Who makes it?

IHS Markit prepares the USD Credit Inclusive Term Rate (“CRITR”) and the USD Credit Inclusive Term Spread (“CRITS”). CRITR and CRITS are published at 8:00 AM ET daily¹ on a T+1 basis in alignment with SIFMA’s holiday calendar. They can be found here.

CRITR and CRITS are in compliance with the UK Benchmark Regulation and the IOSCO Principles for Financial Benchmarks.

How Is the Rate Calculated?

CRITR and CRITS are forward-looking dynamic term rates that measure the daily USD cost of funding in institutional markets. They are designed to give banking institutions a broad measure of USD funding costs on a senior unsecured basis. CRITR and CRITS are based on constituent bases, tracking most transactions concerning certificates of deposit, commercial paper and short-term corporate bonds.

To calculate CRITR, IHS Markit filters qualifying transactions to use in its calculation procedure. If filtering produces a transaction count for a given tenor below the threshold needed for the calculation procedure, then IHS Markit pulls transactions from the prior day until either the threshold is met or data has been pulled from the prior five business days. During the calculation procedure, IHS Markit buckets various transactions to determine weighted median yields across all qualifying transactions, removing outlier data in the process. For each tenor, the final rate is based on the weighted average of the weighted median yield over the past five business days.

To calculate CRITS, IHS Markit takes the CRITR for a given tenor and subtracts the relevant SOFR swap rate²  at the target maturity.

IHS Markit does not set a floor (i.e. a minimum limit) for either CRITR or CRITS.

What Tenors are Available?

CRITR and CRITS are available in the following tenors: 1 Day, 1 Month, 3 Month, 6 Month and 12 Month.

Bloomberg Short-Term Bank Yield Index (“BSBY”)

Who Makes It?

Bloomberg prepares BSBY. It is published on Bloomberg Terminals under the tickers BSBYON, BSBY1M, BSBY3M, etc. (depending on the relevant tenor), at 8:00 AM ET daily. It can be accessed via the Bloomberg Terminal and will be posted publicly on Bloomberg.com on a delayed basis.

BSBY is compliant with the IOSCO Principles for Financial Benchmarks, based on an independent assurance review announced on April 6, 2021.

How Is the Rate Calculated?

BSBY is calculated using anonymized transactions and executable quotes of a three-day rolling period with no subjective input, rounded to five decimal points. The rates are based on instruments that have averaged more than $200 billion sourced from Bloomberg’s FX and money market electronic trading solutions and trades of senior unsecured bank corporate bonds. Bloomberg calculates the term years using a localized, trimmed curve-fitting methodology. This curve-fitting methodology is a part of BSBY’s calculation contingency, which also discounts executable transaction quotes by scaling them by 12.5% versus executed transactions. If a minimum volume threshold is not met for a specific tenor, that tenor is calculated using a longer lookback window to reach the necessary volume.

Bloomberg has indicated that BSBY will soon be available for licensing through its affiliate Bloomberg Index Services Limited (“BISL”) in additional jurisdictions, including in the U.K. and the EU. As of May 19, 2021, BSBY is Bank of America’s preferred benchmark replacement for corporate loans.

BSBY has no built-in floor or spread adjustment.

What Tenors are Available?

BSBY is available in the following tenors: Overnight, 1 Month, 3 Month, 6 Month, and 12 Month.

ICE Bank Yield Index

Who Makes It?

ICE prepares the Bank Yield Index. The Bank Yield Index is published daily on the ICE website, and test results can be accessed here.

As of the latest update from ICE in May 2020, the IBA is still seeking external assurance regarding compliance with IOSCO Principles for Financial Benchmarks. The IBA plans to continue and observe outcomes against LIBOR, but there is no guarantee that the IBA will continue with testing or publication of the Bank Yield Index.

How Is the Rate Calculated?

The ICE Bank Yield Index is a forward-looking transaction-based benchmark derived from: (i) primary market whole, unsecured funding transactions sourced from large, internationally active banks, and (ii) secondary market transactions in wholesale, unsecured bonds issued by large, internationally active banks. Calculations are based on transaction data for a rolling five-day collection window.

Across the five days, a minimum aggregate funding transaction volume of $15 billion is required across all eligible transactions. A minimum eligible transaction count of 100 is also required.

All transactions are initially equally weighted, regardless of transaction size. A maximum weight threshold, which is 10% of the total weight of bond transactions and 15% of funding transactions, is calculated. Transactions that exceed these thresholds are reduced proportionately in transaction weight. An outlier filter identifies data points farther than the threshold (currently 200 basis points) from the fitted curve. These are removed from the set of transactions and the robust regression is recalculated.

ICE does not appear to set a floor for the Bank Yield Index.

What Tenors are Available?

The ICE Bank Yield Index is available in the following tenors: 1 Month, 3 Month, 6 Month, and 12 Month, from the curve values at 30, 91, 182 and 365 days to maturity, respectively.

AMERIBOR

Who Makes It?

AFX prepares the American Interbank Offered Rate (“Ameribor”). Ameribor is published every night by Cboe Global Markets, Inc. (“Cboe”) under the ticker ‘AMERIBOR’ and is accessible here. Ameribor is in compliance with the IOSCO Principles for Financial Benchmarks.

How Is the Rate Calculated?

Ameribor is an interest rate benchmark calculated as a volume-weighted average of the daily transactions in the Ameribor overnight unsecured loan market on the AFX, which is a self-regulated exchange that has operated since 2015. Ameribor is an interest rate expressed on an actual/360 day count and following business day convention basis that is rounded to the fifth decimal place.

Ameribor’s use has greatly expanded since its introduction in 2015 to around $2 billion average daily volume. It has a historical correlation with LIBOR of more than 99%.

When AFX is closed, such as on weekends or holidays, or if AFX is disrupted, the previous day’s rate is used. Upon the occurrence of an unforeseen exogenous event (such as an event or circumstances which have a material impact on the credit markets), Ameribor is determined based on the recent historical Ameribor benchmark interest rate spread in relation to the effective federal funds rate (“EFFR”). Such spread will be determined as the average differential between the EFFR and Ameribor during the prior 90 business day period. The spread will then be added to the daily closing EFFR on the relevant day in order to determine the closing Ameribor benchmark interest rate for that day until such time as the AFX Committee on Benchmark Oversight determines that the unforeseen exogenous event has been terminated.

There is no built in floor for Ameribor, and Ameribor futures can reflect zero or negative rates.

What Tenors are Available?

The headline rate for Ameribor is an overnight tenor, but there are 1 Month and 3 Month tenors that were introduced as of 2019.

Next steps

To explore and stay on top of the latest updates regarding LIBOR, SOFR and credit sensitive rates, please contact a member of the Hogan Lovells banking team.

Click here to download a summary chart of USD credit sensitive rates for LIBOR replacement: