US banking regulators recently issued guidance giving banks greater freedom in their choice of alternatives to the LIBOR interest rate benchmark, which is set to sunset in 2021. That is good news for banks who are looking for choices to price loans and, in our view, good news for the capital markets in general.
Reed Whitman, treasurer at Brookline Bancorp, recently told the ABA Banking Journal, “This is another step on the march toward the legitimacy of alternative benchmarks and for the market to decide what the replacements for Libor will be.” He added that this gives more confidence that “products we develop tied to a non-SOFR rate will be accepted; it’s an additional accelerant.”
Some banks are reluctant to give up LIBOR, which has been in use since the 1970s. I believe the hesitation in making this transition is understandable but the sooner we get rid of scandal-ridden Libor, the better. The post-Libor landscape offers a world of better options for lenders, including multiple benchmarks, transparency, efficiencies, lower costs and greater innovation.
LIBOR, which was based on a poll of international banks, is no longer viable. Since it was estimated rate, it is akin to electing the president of the United States based on a national telephone opinion poll instead of a national election. We can and we will do better.
Having multiple benchmarks will enhance market efficiency and drive down transaction costs. In the U.S., we are seeing growing adoption of the Federal Reserve’s Secured Overnight Financing Rate, or SOFR, which is derived from borrowing and lending activity using Treasuries as collateral. Others such as AMERIBOR®, short for American Interbank Offered Rate, which is based on overnight unsecured lending on the American Financial Exchange (AFX) that we co-founded. Both benchmarks are transparent and offer capital markets participants a choice of secured, in SOFR’s case, and unsecured, in AMERIBOR’s case, options. Internationally, there are the British government’s Sterling Overnight Interest Average, or Sonia, rate, the Japanese Tonar and the Swiss Saron.
The transition will also lead to greater innovation. AFX connects borrowers and lenders across the U.S., creating, for the first time, a national market for unsecured lending. AFX also has its data on the blockchain. This is a first-of-its-kind initiative to provide greater transparency to market participants, regulators and academics. Unlike other markets that only provide time, quantity and price transaction information, AFX now has records with additional data fields related to each transaction. This additional data includes: the entire order book at the time of each transaction; geographical region of the counterparties to each transaction; and detailed counterparty information such as credit rating, type of institution and detailed financial metrics for each counterparty.
Since AFX has members in all 50 states, this data provides a wealth of information for analyzing and anticipating capital flows among different areas of the country. It can benefit members by helping them better understand trends and patterns in the marketplace. It can also be of value to researchers and regulators who can use the data for research and policy.
The world after Libor will provide many more options to lending institutions than before. One size need not fit all. A choice of multiple benchmarks will make the lending market more like other markets, all of which have a plethora of benchmarks like the commodity markets (with three different kinds of wheat), oil (Brent, WTI, Dubai) and equity (S&P 500, Dow Jones Industrial Average, Nasdaq, the Russell 2000, EAFE and many more) markets.
Economics teaches us that it’s best to have choices. Choice will allow banks and their customers to have access to a truly representative American rate. All market participants will benefit from increased transparency as benchmarks reflect financing activity in real time.
The lending markets will be more diverse, and market efficiency will increase. I urge those who are hesitant about leaving LIBOR to consider it an opportunity.
Richard Sandor is the Aaron Director Lecturer in Law and Economics at the University of Chicago Law School and chairman and CEO of the American Financial Exchange, an electronic exchange for direct interbank lending and borrowing.