July 8, 2021 - by Meredith Coffey. The rates world has been abuzz about, well, a future “multi-rate” world whereby risk-free rates (“RFRs”, like SOFR) may coexist with credit sensitive rates (“CSRs”, like BSBY, Ameribor, BYI, CRITR and AXI). The financial regulators have generally endorsed the broad use of RFRs; meanwhile market participants note that RFRs probably work for most products, but CSRs may play a distinct role in lending. The LSTA does not take a position on which replacement rate parties should adopt – we are working to effectuate all potential replacement rates – but we do believe that parties should make well-informed decisions. To facilitate this, below we drill into a specific debate taking place over RFRs and CSRs.

On June 11th, the Financial Stability Oversight Council (“FSOC”) met to publicly discuss the money markets and LIBOR cessation. All went as expected – regulatory heads warned that money market reform was coming and that the markets had to get off LIBOR and onto SOFR (and CSRs in a limited fashion) – until the SEC Chairman spoke. Mr. Gensler, it seems, is no fan of LIBOR and had some harsh words for CSRs (and BSBY specifically, possibly because it is a “rate that a number of commercial banks are advocating as a replacement for LIBOR”). The criticisms focused primarily on i) the “inverted pyramid” problem (whereby $200 trillion of contracts depended on LIBOR, which had less than $1 billion of daily transactions), ii) the potential for manipulating the rate (which led to LIBOR’s downfall) and iii) the potential fragility of the money markets that underpin BSBY. The speech sent shockwaves through the (admittedly geeky) LIBOR transition world.

On July 1st, Bloomberg released a paper addressing a number of these concerns. First, it acknowledged that RFRs will be the “primary alternative rates that will form the backbone of the financial markets post-LIBOR.” SOFR is very robust and is underpinned by nearly $1 trillion of daily underlying Treasury Repo transactions, and thus is not plagued by the inverted pyramid problem, potential manipulation questions or money market reform issues.

The very fact that SOFR likely will be the primary reference rate for derivatives (and likely most FRNs, consumer loans and securitizations) makes the inverted pyramid problem go away. To wit, there should not be a massive amount of derivative contracts (the top of the inverted pyramid) resting on relatively few credit sensitive transactions (the bottom of the inverted pyramid). Let’s talk numbers. Figure 3 on p. 7 of Bloomberg’s paper scopes the estimated use cases of BSBY. While LIBOR currently is the reference rate for $220 trillion of contracts, the vast majority of CSR use cases apply to an estimated $6.2 trillion of commercial and business loans, with some spillover into derivatives primarily for the purpose of hedging the CSR loans. For these more limited market segments, BSBY should be considered sufficiently robust; there is an average of $200 billion of observed underlying transactions in a rolling three-day window underpinning the rate, Bloomberg notes.

Bloomberg also addresses the manipulation concern by contrasting the manipulability of LIBOR vs SOFR. First, there were very few LIBOR setters, who were not necessarily on opposite sides of transactions. In contrast, the money markets that underpin BSBY are composed of many buyers and sellers with competing objectives. Moreover, someone attempting to manipulate the CP/CD market could easily lose a lot of money (again, in contrast to LIBOR). And, ultimately, Bloomberg tested manipulating the transaction data and it moved BSBY an immaterial amount.

Finally, on the money markets and their potential reform. Bloomberg notes that CP outstandings are at their highest point in six years, but also acknowledges that some believe money market reform could have a large impact on prime and tax-exempt money market funds. However, Bloomberg notes that Prime Funds hold 19% of CP outstanding, meaning that the vast majority of CP is in other hands.

As mentioned previously, the LSTA is not recommending particular rate – see our many SOFR posts on www.lsta.org – but instead believes that market participants should make informed decisions. This discussion is just one more datapoint in the LIBOR replacement decision.

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