Sebastian Pellejero and Mark Maurer used their December 30, 2021, Wall Street Journal column to discuss some of the history of LIBOR, and now, its end. See “Some Companies Are Ready for Libor’s Demise, but Not All,” https://www.wsj.com/articles/some-companies-are-ready-for-libors-demise-but-not-all-11640869202. We note that Sebastian is a Camp Kotok 2021 attendee and contributed in detail to the conversations we held in Maine last August.
In sum, LIBOR is dead, officially and actually. So we won’t spend a lot of time recounting the history of its start in 1980s, its three-decade expansion and flourishing, its worldwide acceptance, the misdeeds of a few people whose bad behavior triggered change, or the evolution of that change, which took many more years than originally expected. For background on the history, we recommend this link: “Libor Rate History Compared to Fed Funds Rate,” https://www.thebalance.com/libor-rate-history-compare-to-the-fed-funds-rate-history-3306123.
I was a panelist in the early stages of this change as a series of worldwide meetings occurred on developing the substitute and revising contracts involving trillions. That was many years ago, and this obituary for LIBOR had its first draft then. LIBOR was terminal long before Covid.
Now we are in the SOFR business. The Secured Overnight Funding Rate is the official substitute for LIBOR. SOFR is complex, and the bugs are mostly worked out, although it has survived the early and most difficult shocks. It is replacing LIBOR as the global reference in contracts that are measured in the trillions. And SOFR is entirely controlled by the Federal Reserve. The Fed has unlimited ability to set SOFR yields at whatever it wants. Currently, that yield is 0.05%, or five basis points. Note that SOFR is essentially matched against the repo rate, which is also effectively controlled by the Federal Reserve.
But what is missing from this new system?
We believe that the missing element has been the ready means to estimate the condition of the worldwide banking system in the land of US dollar funding. A financial stability indicator was an ingredient achieved with LIBOR. If the system were stressed, LIBOR member banks would alter their bids for funds because they saw a change in credit risk profiles. Remember that LIBOR was an unsecured rate used between the very largest banks. SOFR and others are secured, so risk is not a component of the yield. Liquidity in market clearance and system operational stability are components, but credit risk is missing.
BSBY, the Bloomberg Short-Term Bank Yield Index, comes to the rescue.
Bloomberg users and TV watchers will see BSBY quotes on their TV screens from time to time. At Cumberland, we track BSBY daily and develop our own internal forward yield curves using BSBY. The bottom line is that BSBY gives us an indication of stress or lack of stress in the banking system. Prior to BSBY, we had to estimate that stress by using the difference in yields between (1) the money market funds that contained bank paper and weren’t all government funds and (2) the 100% government funds. This was a rough way to gauge credit stress. With BSBY, the hard work is done for us.
Here's a quote from a BSBY research paper and a link to the entire paper: “Bloomberg Short-Term Bank Yield Index,” https://assets.bbhub.io/professional/sites/27/Bloomberg_BSBY_Report_070121-1.pdf.
“Bloomberg developed BSBY in response to requests from a number of lending market participants. These firms were seeking a series of credit-sensitive reference rates that measure the average yields at which investors are willing to invest USD funds on a senior, unsecured basis in systemically important banks. BSBY was developed to complement SOFR by providing the lending market with an index that can help banks with asset/liability management (ALM) to better ensure availability of funds during times of market stress.
To underscore the importance of this complementary relationship, a seminal report by the Bank of International Settlements (BIS) 2 stated:
“...the new RFR-based benchmarks clearly fulfill the first two of the three desirable features of an all-in-one benchmark rate. Where they seem to fall short is the third key feature, i.e. serving as a benchmark for term funding and lending by financial intermediaries. Term rates derived from market prices for RFR-linked derivatives (e.g. OIS or futures) will readily yield a risk-free term structure that can be used for discounting purposes and fulfil various needs in the market. But banks will still lack a benchmark that adequately reflects their marginal funding costs as a substitute for LIBOR. This speaks to the limitations of using O/N rates, instead of those based on term transactions, to create term benchmarks....”
Since then, there have been several efforts to remedy this gap including, for example, fixed spreads over term RFRs. Such rates may likely benefit borrowers in the current environment but still do not mitigate funding stress and the associated ALM mismatch that bank lenders would face in a counter-cyclical rate environment, as discussed in more detail later in this report.
BSBY is designed and produced in alignment with the IOSCO Principles for Financial Benchmarks (IOSCO Principles). The rate is based on consolidated, anonymized transaction-related data and firm executable quotes of commercial paper.”
So we now look at BSBY and all the other traditional credit spreads in the corporate and municipal bond markets.
Where are we now as we enter 2022?
Right now, there are no apparent serious stresses in the credit markets. Spreads are very tight in nearly all categories. So the market is not pricing in any credit stress. Note that markets price in the consensus of those market agents who are real-money folks; and markets may hear the noise of pundits, but those market prices reflect actual decisions and not just talking heads’ opinions. We respect market-based prices much more than we do pundits.
Welcome SOFR and welcome BSBY.
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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.