Since the United Kingdom’s Financial Conduct Authority announced in 2017 that it would no longer sustain the London Interbank Offered Rate (LIBOR) after the end of 2021, there has been much discussion regarding the replacement benchmark.
In the U.S. in particular, there has been much confusion on what the post-LIBOR world will look like.
In March 2021, the United States Federal Deposit Insurance Corporation, with the Federal Reserve Board and the Office of the Comptroller of the Currency, released guidance encouraging all new financial contracts to cease utilizing LIBOR as soon as possible.
The one-week and two-month U.S. Dollar (USD) LIBOR tenors will cease to be published after Dec. 31, 2021, and the rest of the USD LIBOR tenors used in the context of preexisting financial contracts will follow suit after June 30, 2023. New financial contracts will not be permitted to use LIBOR after Dec. 31, 2021.
Two Front-runners: SOFR vs. BSBY
Although there still is no certainty for which benchmark will replace USD LIBOR, two front-runners have emerged: the Secured Overnight Financing Rate (SOFR) and the Bloomberg Short-Term Bank Yield Index (BSBY).
Patricia J. Lane, Chicago, is a partner with
Foley & Lardner LLP, Milwaukee, where she practices in finance.
Louis E. Wahl IV, Minnesota, is an associate with
Foley & Lardner LLP, Milwaukee, where he practices in finance.
Corrie E. Osborne, Chicago, is an associate with
Foley & Lardner LLP, Milwaukee, where she practices in finance.
SOFR was identified as the presumptive replacement for LIBOR in 2017. SOFR is administered by the Federal Reserve Bank of New York, and is an overnight-secured, risk-free reference rate based on transactions in the U.S. Treasury repurchase market.
In July 2021, the Alternative Reference Rates Committee (ARRC) solidified its support for SOFR by selecting Term SOFR, a forward-looking rate determined by market expectations of future SOFR settings, as ARRC’s preferred successor to USD LIBOR. However, while SOFR’s underlying transactions are robust, its risk-free nature and BSBY’s relatively high correlation with LIBOR has caused some market participants to prefer BSBY as the replacement benchmark.
BSBY, first made available to trade in March 2021, is considered by many market participants to be a front-runner among the credit sensitive rates to replace LIBOR. Published by Bloomberg, BSBY attempts to overcome the drawbacks of both LIBOR and SOFR (albeit to a lesser extent in respect of the forward-looking Term SOFR).
In April 2021, the International Organization of Securities Commissions stated that BSBY complied with their Principles for Financial Benchmarks. With its one-, three-, six-, and twelve-month term structures, systemic credit-sensitivity spread, and its broad transactions base, BSBY looks like a good contender for replacing LIBOR.
While BSBY has not been used broadly yet, there are several notable BSBY-based loans in the market that indicate that BSBY is gaining traction, including Knight-Swift Transportation Holdings Inc.’s September 2021 $2.3 billion unsecured credit facility.
Moreover, in response to the increasing demand for credit-sensitive instruments, CME Group launched interest rate futures based on BSBY earlier this year, and expects to launch cleared BSBY interest rate swaps starting Nov. 15, 2021. An active derivatives market is crucial to the development of BSBY.
BSBY has several advantages over both LIBOR and SOFR that make it a contender to replace LIBOR.
Like SOFR, BSBY is transactional-based, as it is calculated using aggregate data based on transactions of commercial paper, certificates of deposit, bank deposits, and short-term bank bond trades in an attempt to measure the average yields at which investors are willing to access USD on a senior, unsecured basis.
Although it is based on a smaller pool of transactions than SOFR, BSBY is significantly larger and more complex than LIBOR, which makes BSBY more robust and less susceptible to market manipulation.
In addition to its complexity (which diminishes the opportunity for manipulation that ensnared LIBOR), a significant advantage for BSBY is that it is a credit-sensitive rate, similar to LIBOR and with strong historical correlation with LIBOR, thus supporting the role of BSBY as an appropriate representation of the U.S. wholesale, unsecured funding market.
Although BSBY tracks a bit lower than LIBOR, it more closely mirrors LIBOR and is more stable than SOFR – which does not track LIBOR as closely and has already shown that it can occasionally spike if there are spikes in the repo market.
To address the fact that SOFR, as a secured rate, should on average be lower than LIBOR, an unsecured rate, ARRC recommended that contracts that fall back from LIBOR to SOFR use specified spread adjustments based on the five-year historical median difference between LIBOR and SOFR equal to 11.5bps for one-month contracts, 26bps for three-month contracts, and 43bps for six-month contracts.
Unlike SOFR, BSBY is an unsecured rate and should not require much, if any, spread adjustment to transition from LIBOR to BSBY.
The difference in SOFR’s and BSBY’s calculation methodologies is particularly noticeable in the present low interest rate environment, where the current SOFR spread differentials between SOFR and LIBOR are materially lower than historical spread adjustments – including the SOFR spread adjustments recommended by ARRC.
Although there are benefits to BSBY, BSBY has some drawbacks. Foremost among them is BSBY’s complexity, which cuts both ways.
BSBY has a complicated arithmetic underpinning, and it is unclear how Bloomberg weights the data it uses to compile BSBY. Further, the data undergoes quite a few changes before it is published as the index – which may defeat the purpose of having an index that is based on transactions to avoid potential manipulation.
This added complexity may also mean that BSBY is not actually reflecting the value of money, as it undergoes complex arithmetic manipulation to convert it from the data itself.
Conclusion: A Tie?
One thing is certain in the race toward the LIBOR transition – the replacement rate is still uncertain. As BSBY attempts to overcome the downfalls of SOFR, it is possible that both rates will be used, since they complement each other instead of compete with each other. In that case, financial institutions will be able to pick whichever rate best suits their needs, and the presence of multiple rates might create a market inhospitable to manipulation.
Regardless of what happens over the coming months as LIBOR is transitioned out permanently, this area is certainly one to watch, given its importance for financial transactions.
This article was originally published on the State Bar of Wisconsin’s
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