Credit sensitive rate alternatives do not address all of Libor’s weaknesses, says BoE

The Bank of England (BoE) has warned markets not to risk progress made in the Libor transition by depending on credit sensitive rates.

“Many of these new credit sensitive rates continue to reference [commercial paper and certificates of deposit markets] and when liquidity drops away they seek to expand their ‘daily’ data sets through the use of rolling windows, giving the appearance of larger underlying volumes,” said Andrew Bailey, Governor of the BoE, in a speech given at the Alternative Reference Rates Committee’s Sofr Symposium.

“It is therefore not clear to what extent alternative credit sensitive benchmarks have truly addressed the weaknesses of Libor.”

The market itself is split on the need and use cases for credit sensitive rates as part of the transition away from Libor.

In a discussion a day before Bailey’s remarks during ISDA’s annual general meeting, Sonali Theisen, head of FICC E-Trading & market structure at Bank of America said: “We think it’s at least worth the market having options.”

There are currently four credit sensitive rates being published or scheduled to be rolled out, Ameribor by AFX, BSBY from Bloomberg, the Bank Yield Index published by ICE and IHS Markit’s USD CSA.

Last week, Bank of America and JPMorgan conducted the first basis swaps using BSBY.

“There’s significant interest in having [credit sensitive rates] alongside Sofr. We do think it will accelerate the transition to Sofr for much of the derivatives market,” Theisen said.

Though there is demand for credit sensitive rates, Jack Hattem, managing director of global fixed income at BlackRock believes the lion’s share of liquidity will remain in Sofr but a better understanding of the appropriate use cases of credit add-ons will be key in transitioning the market.

“Education becomes very important,” he said. “You have to understand the construction of these alternative indices that involve the credit component. How are they made, what is the appropriate fit, then what’s the liquidity in those products and is there liquidity in derivatives for effective hedging purposes.”

“Once you evaluate all of those, then you can decide what’s the most appropriate.”

Limited use cases

Other panelists were not as optimistic about the general use of credit-sensitive rates.

“The general message we have heard from regulators is that implicitly, there’s not enough volume out there in credit sensitive rates for it to be representative,” said Chris McAlister, global head of derivatives trading at Prudential Financial.

“The jury’s still out. We’re very early in it but I definitely have more concerns about it than I do have confidence that it’s a good alternative except for very limited use cases.”

So far, all credit sensitive rates are published only for USD. Demand for a credit add-on on the other side of the Atlantic is considerably lower, according to Chirag Dave, executive director of sterling rates trading at Goldman Sachs.

“In the UK, there isn’t necessarily that same demand for a credit sensitive index.”

Compared with the US, the lending market in the UK is less fragmented with the large banks being the bulk of the market. A major driver for Sofr credit-addons in the US has come from regional banks.

“The fact is the US is a bigger market and therefore has capacity to potentially support a credit sensitive index in terms of the underlying transactions which isn’t necessarily the case in the UK,” said Dave.

However, as tail risks seem to become more frequent, Dave warned during times of crisis the spread between risk free and credit sensitive rates widen significantly and that potential exposure should be reviewed by loan market end users.

“In a time of crisis, I think it’s worth seriously considering whether you actually want that exposure as a borrower to higher rates when credit spreads blow out,” Dave said. “Banks are always going to offer Sofr loans because the regulators have gone in that direction.”

Bailey echoed similar sentiments in his speech: “In the UK there is a clear consensus that credit sensitive rates are not required or wanted as part of sterling Libor transition and in my view this is sensible. Widespread use of risk-free rates will ensure we are using benchmarks that will remain transparent to users and embed rates that have long-term durability for the future.”