Prepared Remarks at the City & Financial Global Virtual Summit on Managing LIBOR and IBOR Transition. “The Case for an Across-the-Curve Credit Spread: Transitioning from LIBOR Sustainably”.
June 10th, 2021. Mr. Marcus Burnett. Thank you Nav (Navin Rauniar), and thank you to City and Financial for the opportunity to share some thoughts today. In a world where we are not always able to communicate in person, virtual conferences such as these provide an important forum for market participants to exchange ideas on key issues impacting financial markets, including the complex and global transition away from Interbank Offered Rates.
My name is Marcus Burnett and I lead the executive team at SOFR Academy where our mission is to empower people, organizations and communities to succeed through world class learning. Our team is a group of leading academics and financial services professionals focusing on issues that affect financial markets and the global economy such as the monumental transition away from LIBOR towards more robust reference rates like the Secured Overnight Financing Rate (SOFR).
Our panel of advisors includes leading academic minds from institutions including Harvard University, the Massachusetts Institute of Technology, New York University, the University of California Berkeley and today we announced the appointment of Professor Xiaoyan Zhang, Associate Dean of the People’s Bank of China School of Finance, Tsinghua University to our Board of Advisors. The firm has evolved to operate at the intersection of finance, academia and public policy. Our work is separate from but supportive of the Alternative Reference Rates Committee (ARRC), the group of private-market participants convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition from U.S. dollar LIBOR.
From the establishment of SOFR Academy, we knew that we did not want to go-to-market like a transitional firm, rather, we wanted to use technology to achieve our mission. This approach became even more important with the onset of the COVID-19 pandemic. Since the inception of our firm, we have now reached more than 36,000 individuals in more than 190 countries. We believe this reflects the important global funding role that the US-dollar plays as the worlds reserve currency. Turning to our services for enterprise, although the majority of our organizational clients are located in traditional money centers like New York and London, we’ve also been fortunate to help organizations in other parts of the world where U.S. dollar transactions are prevalent. For example, we provided educational services to a Development Bank that represented 22 countries across a range of geographies. U.S. Dollar LIBOR transition is very important for a number of markets outside of the United Sates. Based on our client observations, Africa, South America and countries around the Persian Gulf are particularly concerned with U.S. dollar LIBOR transition. We believe that for LIBOR transition to be successful, it must be broad based.
I began my career as a short-term interest rate derivatives trader and I have been involved in LIBOR transition in the United States and the United Kingdom since 2016, having participated in some of the early working groups in London chaired by the Financial Conduct Authority and attended by the Bank of England. Before we move on, I’d like to note that the views I express are my own, and not necessarily the views of SOFR Academy’s Board of Advisor or our clients.
The SOFR was identified by the ARRC as their preferred replacement for USD LIBOR. Unlike LIBOR, SOFR does not contain a credit risk component or a forward-looking term structure. This has spawned much industry discussion and given rise to new Credit Sensitive Rate (CSR) proposals. Most of these CSR’s generally seek to emulate LIBOR. All but one.
When determining which of the CSR’s are suitable, leading institutions should consider the interests of their counterparts, their clients, their regulators and the American economy at-large, including non-financial corporations. Another fundamental requirement of any CSR is sustainability in the face of future regulatory changes or evolving market conditions. In the words of Bank of England Governor Andrew Bailey, “We need to learn the lessons of Libor, and ensure we complete this transition in a way that minimises the risk of us having to undertake a similar exercise in the future.” Irrespective of your views on LIBOR transition, there seems to be a general consensus on both sides of the Atlantic that no one wants to do this twice.
An Across-the-Curve Approach
An approach to credit sensitivity that factors in the volume of longer-term bank funding transactions which occur further out the yield curve results in a spread that is less volatile than LIBOR and is representative of actual bank funding costs. Crucially, this representativeness and robustness would be maintained over time, automatically adapting to any potential changes in bank debt maturity profiles.
This approach is the basis for the Across-the-Curve Credit Spread Index (AXI), which was discussed at a series of credit sensitivity workshops hosted by the Federal Reserve Bank of New York, more formally titled the ‘Forum on Ongoing Innovation in Reference Rates for Commercial Lending’. After much discussion and after performing due diligence on a number of the proposals in the fourth quarter of 2020, SOFR Academy worked with an academic commercialization department in the first months of 2021 to reach an exclusive and world-wide agreement to play a role in helping to operationalize AXI.
AXI was conceived in an academic paper by Professor Antje Berndt from Australian National University, Professor Darrell Duffie of Stanford University, and Dr. Yichao Zhu also of Australian National University. AXI is a weighted average of the credit spreads of unsecured bank funding transactions with maturities ranging from overnight to five years, with weights that reflect both transactions volumes and issuance volumes. AXI can be added to Term SOFR (or other SOFR variant) to form a credit-sensitive interest rate benchmark for loans, derivatives and other products. Since AXI is a spread added to SOFR, it leverages the almost decade long work of the ARRC and benefits from the strong foundation that SOFR represents. AXI is calculated as a single number that is then scaled down by a constant scaling factor to create a term structure in tenors that the market is familiar with like Overnight, 1 month, 3 months and 6 months.
Unlike other credit sensitive alternatives, AXI was not developed to replicate USD LIBOR. AXI reflects broader credit conditions based on a deeper pool of transactions and is generally less volatile than a LIBOR-like rate. Criteria that the creators of AXI took into account when developing AXI included:
- Hedging effectiveness: The index should be highly correlated with U.S. bank cost of funds, as determined by recent market credit spreads for wholesale unsecured issues of U.S. banks and bank holding companies.
- Robustness: Computed from a large enough pool of market transactions that the index can underly actively traded derivatives instruments used by banks and their borrowing customers to hedge their floating-rate exposures, without significant risk of statistical corruption or manipulation.
- Adaptable to changes in issuance patterns: The index should, within reason, maintain the first two properties even as banks change the maturity and instrument composition of their issuances in response to changes in regulation and market conditions.
We’ve been very active over the past few months in preparation for the publication of an AXI beta rate from a communications, education and operationalization standpoint. We met with representatives of the Loan Syndications and Trading Association (LSTA), where SOFR Academy is a member, and the International Swaps and Derivatives Association (ISDA). Both associations have indicated that they are taking an agnostic view toward CSRs. We set up a microsite on our website SOFR.org/AXI , we made available an educational video, a centralized inbox for question [email protected], we published a user-friendly infographic and a set of Frequently Asked Questions (which will be continually updated). Together with representation from our academic team, we’ve held numerous dedicated AXI education sessions with individual financial institutions. We believe AXI will be best positioned if it is administered by an administrator authorized by the UK’s Financial Conduct Authority (FCA) to ensure the highest international levels of governance and oversight and compliance with IOSCO principles and European Union Benchmark regulation, so we initiated discussions with a number of potential administrators and we expect to make a selection imminently.
Prioritizing Safety and Soundness
Turning to considerations relating to market safety and soundness, there are also additional macroeconomic efficiencies to be realized by an across-the-curve approach. Referencing a wider and deeper pool of transactions creates a spread that reflects a broader range of credit conditions. This reduces the likelihood and severity of sharp increases in short term rates driven by liquidity events, which have plagued LIBOR in the past, often crippling markets. AXI represents a more stable and moderate compromise between lenders and borrowers.
One such period of short-term bank liquidity stress occurred in March of 2020, when the U.S. Federal Reserve dramatically cut the Federal Funds Rate to support the American economy at the onset of the COVID-19 pandemic. At the same time, LIBOR spiked in response to short term bank funding liquidity constraints. LIBOR’s sharp rise during this period exacerbated the economic problems in myriad ways at the worst possible time. Under SOFR + AXI, banks would not charge corporate borrowers higher interest payments in times of bank funding stress. This is because unlike LIBOR, AXI is not limited to the short-term unsecured funding markets that have withered away since the global financial crisis and is therefore not vulnerable to short-term illiquidity effects.
Reducing the likelihood and magnitude of this type of countercyclical scenario would increase the efficiency with which the Fed’s monetary policy decisions feed through to the real economy. Addressing the demand for a CSR while not relying on the markets that once underpinned LIBOR would go a long way toward ensuring easier and fairer financial conditions for those who need the most help during a financial crisis.
Fed Chair Jerome Powell has stated more than once that the recent economic downturn has not fallen evenly on all Americans, and those least able to bear the burden have been the hardest hit. At a time where the U.S. is re-establishing its position of leadership on a number of key global issues, lets also choose to be leaders in LIBOR transition. Even though it may be a bit more difficult in the short term, lets transition from LIBOR fairly, sustainably, and with a longer-term focus from which we will all ultimately benefit.
In conclusion, AXI is different to the other CSR proposals in a few important ways: (1) it takes into account funding transactions that occur out to 5-years so it’s not reliant on the short-term markets that once underpinned LIBOR, (2) it is a credit spread add-on to SOFR, not a standalone rate and (3) AXI automatically adapts to changes in bank funding composition, so its representativeness and robustness is sustained over time. We generally refer to [SOFR + AXI] as being a LIBOR alternative rather than just AXI by itself. We’ve received strong market demand for AXI and will be making an announcement regarding it’s FCA authorized administrator shortly to position for global usage.
Once again, thank you to City & Financial Global for the opportunity to share some remarks and for hosting this summit on such an important issue. I look forward to your questions.
Marcus Burnett is Chief Executive of SOFR Academy based in New York. For press enquiries please contact [email protected]