The world of financial regulation is, unlike global capital, respectful of national boundaries. That’s especially true when those boundaries belong to the biggest of all financial players — the US.
So we’ve been somewhat surprised that the top ranks of UK officialdom have seen fit to wade into how the US is handling efforts to transition from Libor to alternative benchmarks to underpin floating-rate financial products (of which, in America at least, there are many). We think, for the reasons set out below, this will have some implications for how businesses based in Britain do dollar borrowing.
As with everything Libor-related, we need to backtrack a little and explain what’s going on here.
The nearest thing the US has to an official Libor replacement is the Secured Overnight Financing Rate, dubbed Sofr. Sofr, which is based on the cost of securing overnight funds in the repo markets against US Treasuries, is produced daily by the New York Fed and endorsed by numerous arms of financial officialdom.
That seal of approval has not stopped other alternatives emerging, many of which — such as BSBY and Ameribor — are credit-sensitive, meaning that they, like Libor, incorporate credit risk in a way that Sofr, as a measure of secured overnight funding, does not. The reason being that those credit-sensitive rates, by definition, offer a term component, which gives lender and borrower certainty about what their payment will be ahead of time. (More on this here.) Alternatives such as BSBY are, unlike Libor, largely based on actual transactions — though those transactions have nowhere near as much volume as the repo market.
US authorities’ attitudes to these myriad rates competing to replace Libor has been somewhat confusing. While they will willingly tout Sofr’s benefits, such as its being based on a far larger and more liquid pool of transactions, they’re unwilling to ban the use of the alternatives. The view in the US is that the decision on which benchmark to apply lies with the parties on either side of a transaction. For regulators to argue otherwise would be to overstep their authority.
These multiple alternatives are complicating the transition away from Libor in the US. In the UK, meanwhile, there is consensus that Libor ought to be replaced in most contracts with Sonia, a rate produced by the Bank of England, which measures overnight unsecured borrowing costs.
It seems that UK regulators are finding the delay in the US all rather annoying. We imagine they’re not best pleased that they’ve had to extend the life of the most popular dollar Libor fixings beyond of the end of this year to the middle of 2023. Which perhaps explains why they’ve taken the step of wading feet first into the debate about what will replace dollar Libor.
So what are their complaints exactly?
Bank of England governor Andrew Bailey said back in May that many of the credit-sensitive rates seeking to replace Libor risked falling into the same trap as the failed benchmark. The reason being that he thinks they rely on transactions in markets where activity has a tendency to vanish in times of panic:
The creators of Ameribor insist these dry spells did not occur. Sofr has experienced bouts of volatility too, notably in the autumn of 2019.
That’s not stopped Edwin Schooling Latter (his real name) of the Financial Conduct Authority going even further than Bailey. Earlier this month he called out some of those Sofr alternatives by name and warned businesses would be ill-advised to use them without regulators’ explicit consent (our emphasis):
Do businesses this side of the Atlantic mind regulators wanting their dollar borrowing being entirely linked to Sofr? It seems so. Many, keen for a term rate, are looking at alternatives. Here’s Claude Brown, the partner at Reed Smith who’s in charge of Libor transition:
There are plans under way to create a term rate based on Sofr. The hope is that this will temper interest in the likes of BSBY. Yet the timing of its introduction is uncertain and, as Brown puts it, “until term Sofr is actually out there, people will use what they see.” Once people are comfortable with BSBY, they may not wish to switch.
If the regulators in the UK put their foot down, we could end up with a strange situation where dollar borrowing in the UK and the US relies on very different benchmarks, creating all sorts of arbitrage opportunities.
Multinationals will cope. But all this is yet another instance that illustrates how the relative simplicity we have had until now is about to be replaced by an altogether more complex world.
Related linksLibor’s US replacements: no one rate to rule them all — FT AlphavilleDo US rules to fix Libor’s legacy go far enough? – FT AlphavilleWhy Libor’s demise threatens small businesses the most – FT Alphaville