Game of Benchmark: US Season 2?

In August 2017, I started a series called "Game of Benchmark: Season 1" with a catch-line

Game of Benchmarks: a no-fantasy series with no blood and no sex but plenty of greed, manipulation and money.

The Episode 1 was titled "the king is dying" and I asked "Where is the successor?"

In the mean time, the king has proved to be more resilient than expected and his death has been delayed to July 2023.

The grace period has been accompanied with new announcements that may partly answer to the question I asked four years ago: Where is the successor?

With the slow king death in the background, some foreign powers have tried maneuvering to push a new officer in power. In this context the term foreign should be understood in part as meaning of a different country but also belonging to another area. The other country is obviously referencing to the UK FCA that, not so subtlety, tried to interfere with the USD market. But maybe more importantly the LIBOR was a market construction, developed by the market for the market. What are the FCA, BoE, Fed and ARRC doing in this story, I don't know. They look very foreign to it, even if in the past, BoE has seen LIBOR as the perfect representation of the interest rate market (it is enough to read the archive of BoE comments after rate decision, to see that it viewed LIBOR as the rate on which their rate policy was measured).

In the USD market, the rate that has been pushed by the regulators and central banks is SOFR. This is a rate based on US Treasury repos and manipulated daily by the Federal reserve [note: Manipulate = Handle or control in a skillful manner]. To understand the level of manipulation of this number it is enough to read the press title from yesterday, like Bloomberg's "Cash Flood Drives Use of Fed Reverse Repo to Record $1 Trillion". The transaction volume on which SOFR is measured is below the same 1 trillion level (877 billions on 29 July). The volume of Fed-related transactions is higher than the underlying market. At the same time the SOFR rate has not moved by one basis point for more than a month. That should certainly be called a manipulation, a very skillful control.

The official "SOFR first day" was last Monday 26 July 2021. Clarus reported 14.3% on Jul 26 and then 20% on Jul 27 for SOFR (rest on LIBOR!). Not really SOFR first yet. We will see the long term results when the volume figures are reported in the coming weeks (see my June analysis).

Last week has also seen the publication in the US on 22 July 2021of House HR 4616: "Ajustable Interest Rate (LIBOR) Act of 2021", a text "To deem certain references to LIBOR as referring to a replacement benchmark rate upon the occurrence of certain events affecting LIBOR, and for other purposes. "

The text was a disappointment for some SOFR aficionados. The text explicitly indicates that no "negative inference [...] regarding the validity [...] of (1) any Benchmark Replacement that is not a Board-Selected Benchmark Replacement; or (2) any changes, alterations, or modifications to or in respect of a LIBOR Contract that are not Benchmark Replacement Conforming Changes.” The text would create a SOFR fallback (i.e. Board-Selected Benchmark Replacement) when none exists but would not kill existing non-SOFR fallbacks.

Last week has also seen the ARRC's decision on Term SOFR. The CME SOFR Term Rates has been recommended. The term rate is now published on a daily basis. It has a limited used. The "limitations" do not make sense from a market and risk management perspective. Roughly you can use it but a liquid hedging market should not be created. This is exactly the opposite that what is useful.

From a risk perspective, SOFR and Term SOFR is (should be) the same. There are some paper out there saying that Term SOFR (or other Term overnight) does not do a good job in hedging risk. But when you read those paper carefully, you notice that the only conclusion that can be drawn from the paper is that the author's have not been able to generate a decent hedging strategy, not that such a strategy does not exists. This was for example the case of the ECB consultation on EURIBOR fallback (see here and here). The hedging strategies exist and are simple (semi-static strategies), you just need to have a decent risk manager (or hired a good advisor) to implement it.

At the very least, each financial organisation should reflect on the SOFR's problem, a problem called by some the SOFR's Voldemort Problem: It’s Time for The Industry to Engage on SOFR’s Voldemort Problem, the one you should not speak about.

Available benchmarks

The list of potential benchmarks is growing every month. On top of the already mentioned and officially sanctioned term SOFR (which is not really a replacement for LIBOR), published for 1, 3 and 6 month tenors, other useful benchmarks are

AFX Ameribor

• Overnight (ISCO compliant)
• Term-30  and Term-90 (ISCO compliant)
• The overnight rate is also the underlying of 30 days and 90 days futures. 
• There is a Ameribor OIS market with market makers, no swap clearing planned yet.
  

Bloomberg BSBY

• UK BMR and IOSCO compliant
• Term rates 1 month, 3 months, 6 months
• Futures planned for 2021 Q3, and clearing for 2021 Q4,
• Tradition quotes

IHS Markit

• Daily Credit Inclusive Term Rate (CRITR) and Credit Inclusive Term Spread (CRITS) for US Dollar Funding
• Rates administered by IHS Markit Benchmark Administration Ltd. (IMBA UK) in compliance with the UK Benchmark Regulation and the IOSCO Principles for Financial Benchmarks.

IBA BYI

• Term rates 1 month, 3 months, 6 months
• Published daily since December 2017 in beta version

Across-the-curve Credit spread index (AXI) 

Weighted average of the credit spreads of unsecured bank funding transactions with maturities out to five years.

Public debate

The "public" consultation by ISDA, ARRC and similar groups are not public; the answers are not publicly visible anywhere, the issues highlighted by the respondents are not addressed. Often some respondent's analysis are more detailed, precise and documented than the documents provided by the group presenting the consultations. Most of the consultation accompanying documents are weak analysis and only confirmed by commercial "validation" without substance. My analysis of the ICE Swap Rate fallback described the type of very superficial validation that was provided. Many one hour public seminars, at university or quality commercial conferences, provide more in depth analysis on those the issues than the documents provided by the official groups.

Stone walling or censuring the debate is not the best way to get a smooth LIBOR transition. You can hide the problems to come by ignoring the issues now, but when the actual transition will come in, the superficiality of the transition will show up. The past value transfer will appear in plain sight.

Value transfer will be visible in EUR (v EURIBOR), JPY (v TIBOR) and in USD (v BSBY, AMERIBOR, IBA BYI, etc). That will open the flood gates of legal challenges. At that stage, the only thing that a quant will be able to do is to witness the disaster and explain what could have been done.

As often in my opinion pieces on LIBOR transition, I hope that I'm wrong, specially on the last paragraph.

Added 2021-08-05: An interesting survey by ABA (American Bankers Association). At the question Which LIBOR replacement rates will your bank use? the answers were (obviously?) at lot of SOFR but also (among others) BSBY for 50%, Ameribor for 36% and EFFR for 31%. This clearly indicates an expectation of a multi-rate framework. SOFR may become the primus inter pares of USD interest rate benchmarks but not the only surviving member and probably not even the king of the tribe.