BankingBloomberg confident in soundness of BSBY as regulators turn up the heat on credit-sensitive rates

Bloomberg confident in soundness of BSBY as regulators turn up the heat on credit-sensitive rates

Slow transition to RFRs for USD Libor causing concern as regulators warn market away from alternate rates

With Libor’s final hour fast approaching, regulatory pressure keeps mounting for market participants to steer away from alternative credit sensitive rates (CSR) and use the overnight risk-free rates (RFR) of Sonia for Sterling and Sofr for the Dollar .

At a conference in London on Monday, the UK Financial Conduct Authority (FCA)’s director of markets and wholesale policy, Edwin Schooling Latter, joined a crowded list of regulators from both sides of the Atlantic sharpening their criticism of CSRs.

“We don’t want to see transition to new so-called ‘credit sensitive’ rates such as [Bloomberg’s] BSBY.”

Regulators take aim at CSRs

Sterling Libor will cease to be published as a representative rate at the end of the year, and while certain USD tenors will continue to be published until June 2023, regulatory guidance will see no new contracts referencing Libor come the first of January 2022.

Back in May, Bank of England Governor Andrew Bailey stated that “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 RFRs,” he continued, “will ensure we are using benchmarks that will remain transparent to users and embed rates that have long-term durability for the future.”

Bailey’s speech was notable by the fact this it was given in a symposium organised by the Alternative Reference Rates Committee (ARRC), the US public-private group responsible for steering US Libor transition.

In the US – a jurisdiction with a larger and more diverse lending market – there has been more of an appetite for CSRs and, only a few months back, regulators seemed to have been more open to alternate rates. But in recent weeks the official sector has begun to change its tone, advocating that markets adopt Sofr, while at the same time discouraging the use of CSRs.

The shift was corroborated by US Treasury secretary Janet Yellen’s remarks to the Financial Stability Oversight Council (FSOC) in June that alternate rates could potentially replicate Libor’s shortcomings.

“The most critical step in the transition is the move toward truly robust alternative rates, like Sofr, which can mitigate the need for future transitions,” she said.

“A failure to adopt robust alternative rates would leave us continuing to face the same risks and challenges that we face today.”

There are primarily four credit-sensitive rates being offering in the US: BSBY by Bloomberg, Ameribor administered by AMX, ICE’s Bank Yield Index and CRITR/CRITS from IHS Markit. BSBY in particular, which has seen some high profile use from banks like Bank of America and JP Morgan, has come under fire from regulators.

“I believe BSBY has many of the same flaws as Libor”, said SEC Chair Gary Gensler in his June remarks to the FSOC. “These markets underpinning BSBY not only are thin in good times, they virtually disappear in a crisis.”

Bloomberg confident in BSBY

While the two top criticisms levied at CSRs are that they are too Libor-like and that the market underpinning the rates are not liquid enough, Umesh Gajria, global head of index linked products at Bloomberg, believes the company has been transparent in how their own CSR, BSBY, is calculated and that the transactions that underpin it are robust.

“We use instruments which banks use to fund themselves such as commercial paper, certificate of deposit, bank deposits, as well as corporate bonds,” Gajria said.

“We use a three-day rolling window, which aggregates about $200 billion worth of data that include executable offers that are supported by IOSCO.”

He added that the construction of the rate makes it difficult to manipulate.

“The transactions that underpin BSBY are between investors and issuers. You have a competitive dynamic already built into that market making it difficult to collude. The issuer wants to get the lowest rate possible and the investor wants to get the highest rate possible.”

However, regulators have argued those instruments are not robust in times of stress, pointing to the drying up of commercial paper liquidity during the March 2020’s credit crunch as proof.

As all CSRs come under more scrutiny, Bloomberg has published additional material last week to address concerns of the robustness of their rate, clarifying that BSBY is meant to compliment – rather than compete with – Sofr.

Mixed US guidance

Meanwhile, demand for a Sterling CSR is small. A combination of factors like a smaller market with less participants and regulatory guidance have tempered needs for one.

“UK regulators themselves have been particularly adamant of their views that Sonia is the most robust rate,” said Andrew Gray, global head of Brexit for financial services and UK lead on Libor transition at PwC.

“It’s the least able to be impacted by market forces that are not fair reflection of the underlying economic costs of the transactions.”

He added that UK regulators started a lot earlier with their Sonia messaging, and therefore had a longer period of time to inform the market of their expectations.

Conversely, the situation appears more complex in the US, where market participants have voiced their discontent with the official sectors’ more recent messaging, pointing out that regulators have flip flopped on the issue.

“There used to be a perceived openness from regulatory communication saying ‘well, it’s not necessarily a one-size-fits-all,’” said Franck Risler, senior managing director of securities, commodity and derivates practice at FTI Consulting.

A joint letter from the Federal Reserve, Federal Deposit Insurance Corporate and Office of the Comptroller of Currency from November last year stated that regulators would not endorse a specific rate, adding that “a bank may use any reference rate for its loans that the bank determines to be appropriate for its funding model and customer needs.”

But recent remarks have demonstrated a clear policy shift.

“We see in the US significant pushback,” said Paul Forrester, partner at Mayer Brown.

“The market is saying we need another rate that is more sensitive and candidly more Libor-like, which freaks the regulators out because of risks of temporary disruptions and potential for manipulation,” he added.

Market fragmentation risks

Market participants believe the pressure regulators are putting on CSRs stems from the fact that, with less than six months to the final transition implementation deadline, much of the dollar market has still not moved away from Libor.

According to the International Swaps and Derivatives Association (ISDA), only 6.8 percent of OTC and exchange-traded derivatives used Sofr in May. In the UK market, which is slightly ahead in its transition, Sonia transactions account for nearly 55 percent of volume.

With the market slow to coalesce around Sofr, regulators are worried there is a risk of market fragmentation.

“The risk in general is fragmentation of liquidity and additional costs,” said Risler.

“If you start to have certain corporate bond using a credit sensitive index, that means derivative markets will consider the potential use of a credit sensitive index. In corporate bonds, floating rates tend to be swapped,” he added.

A surge in popularity of credit sensitive indices in the bond market therefore could impact the swap market.

“If you have a non-insignificant bond market that’s credit sensitive, you’re going to need to have a swap market that’s credit sensitive. Potentially, it’s going to hurt Sofr. I think that’s where you’re getting a lot of pushback from regulators.”

Sofr first

To further enhance Sofr liquidity and speed up the transition, the Commodity Futures Trading Commission (CFTC)’s Market Risk Advisory Committee recommended the market move to a ‘Sofr first’ approach. Starting July 26, interdealers will begin to reference Sofr over Libor, transitioning a large portion of the derivatives market.

“That clearly is expected to be a big boost to the Sofr market,” said Forrester.

With higher liquidity in Sofr, both Forrester and Risler believe the ARRC will have higher confidence in recommending a term Sofr rate, something that is highly anticipated by the market and would further accelerate the Libor transition. The ARRC has already selected the CME to administer a forward-looking term Sofr, but has held off endorsing it until market indicators like growth in Sofr trade volume and higher liquidity are met.

Overall, while the financial industry is not rejecting the regulators’ assessment that RFRs like Sonia and Sofr are the most transparent and robust alternate rates, it is rasing questions about their wider applicability.

RFRs’ soundness “is not the question,” said Forrester. “The more difficult question is whether a Sofr is an appropriate rate and whether it’s fit for the purpose.”

While products like mortgages have already gravitated towards Sofr, middle-market lending firms have shown interests in CSRs.

Libor itself is not a monolith, added Bloomberg’s Gajria. One-month and three-month Libor tenors are used by different people for different products, and already tap into different liquidity pools.

“The market is extremely large,” he said. “That same market is fragmented today and works perfectly fine. We don’t believe, and neither do our clients believe, that [CSRs] will have any effect in terms of fragmenting liquidity whatsoever.”

Reiterating Bloomberg’s view that Sofr will be the primary rate going forward, and their support of the ‘Sofr first’ approach, Gajria added, “the use of CSRs does not mean that people are done with or are not supportive of Sofr.”

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