Prepared Remarks at the Loan Syndications and Trading Association (LSTA) LIBOR transition Q&A Call. An update on the Across-the-Curve Credit Spread Indices (AXI).
November 1st, 2021. Mr. Marcus Burnett. Thank you, Meredith [Coffey], for the opportunity to provide an update on the Across-the-Curve Credit Spread Indices (AXI).
Thank you also to Trey [Berre] from the CME for providing the important information last week on CME Term SOFR licensing and in such a clear and considered way. Index licensing contract terms such as audit rights and aggregate volume reporting are standard industry practice and will likely apply to any index being administered at the highest international standards, including AXI. The general goal of these requirements is not to allow for scrutiny of market participants but simply to allow regulators to understand the extent of usage of an index to ensure that levels of benchmark governance and controls at the administrator are commensurate. Our experience with the CME during Term SOFR licensing and more broadly during LIBOR transition has been consistently positive.
My name is Marcus Burnett, I’m a former interest rates derivatives trader and I lead the executive team at SOFR Academy, a U.S.-based digital education and data provider headquartered in New York. Our team is a blend of academics from universities such as Harvard, the MIT Sloan School of Management, the U.C. Berkeley, NYU, as well as experienced financial services professionals.
Last month, Federal Reserve Vice Chair Randall Quarles said, and I quote: “The principal problem with LIBOR is that it was not what it purported to be. It claimed to be a measure of the cost of bank funding in the London money markets, but over time it became more of an arbitrary and sometimes self-interested announcement of what banks simply wished to charge for funds” (Quarles, 2021). In these comments, Vice Chair Quarles captured the fundamental idea behind AXI. Banks do not fund themselves at LIBOR anymore, they now fund themselves further out the yield curve. As such, there are no longer enough transactions with which to compute LIBOR.
By design, AXI avoids the fundamental flaws of LIBOR. The distinctive component of the AXI methodology is capturing those transactions that occur further out the yield curve, which is a true representation of bank funding costs. It is this feature that makes AXI fundamentally different in construction from any other credit sensitive rate or spread proposal in the market.
AXI was conceived in academic paper by Stanford University professor Darrell Duffie1, Professor Antje Berndt and Yichou Zhu of Australian National University. Professor Duffie chaired a Market Participants Group on Reforming Interest Rate Benchmarks in 2013. That group was established by the Financial Stability Board (FSB). The FSB is an international body that monitors and makes recommendations about the global financial system and was established by the G20 in 2009. Professor Duffie and his collaborators first presented the AXI concept at the series of Credit Sensitivity Group Workshops hosted by the Federal Reserve Bank of New York last year.
In a June letter to the Alternative Reference Rates Committee (ARRC), our Firm committed to operationalizing AXI in a considered and measured way that incorporates feedback and guidance from a wide range of stakeholders and prioritizes the stability of the global financial system. Consistent with this approach, prior to engaging in any broad-based marketing or launching the index, we felt it prudent to firstly allow CME Term SOFR to be formally endorsed by the ARRC and second to allow the CFTC’s Market Risk Advisory Committee’s “SOFR first” initiative to take effect.
Unlike a number of other proposals, AXI was not developed to replicate LIBOR. AXI reflects broader credit conditions based on a deeper pool of transactions and is less volatile than a LIBOR-like rate. AXI was designed by its creators in the spirit with which the IOSCO principles were developed. The three criteria that the creators of AXI took into account when developing AXI included the following:
First, 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.
Second, Robustness: It must be 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.
Third, Adaptability 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.
AXI is a forward-looking, term credit-sensitive spread that reflects banks’ recent marginal funding costs at 1-month, 3-month, 6-month and 12-month tenors. It’s a weighted average of the credit spreads of unsecured bank funding transactions with maturities out to five years, with weights that reflect both transactions volumes and issuance volumes.
AXI is a spread which is added to SOFR. For example, it could be used on top of CME Term SOFR, simple daily SOFR, or other SOFR variants to form a credit-sensitive interest rate benchmark for loans. Importantly, input data for AXI is not confined to the thin, short-term bank funding markets that once underpinned LIBOR. AXI plus SOFR is referred to as SOFRx.
“The principal problem with LIBOR is that it was not what it purported to be. It claimed to be a measure of the cost of bank funding in the London money markets, but over time it became more of an arbitrary and sometimes self-interested announcement of what banks simply wished to charge for funds”– Federal Reserve Vice Chair Randall Quarles
AXI is made up of two main components: The long end bond component (out to five years) where input data is sourced from FINRA Trade Reporting and Compliance Engine (TRACE). And the short end money market component, which is designed to complement the longer end, where data is sourced from the DTCC. Each part is computed separately, and the two components are combined by simple average (see Exhibit 1). Including the long end bond component reduces the overall volatility of the index.
The fact that input data comes only from regulated and publicly available sources is a strength of the index. One of the criteria in the OCC’s recently published LIBOR self-assessment tool which Meredith mentioned last week asks market participants to be able to independently confirm the rates published by the benchmark administrator.
The Financial Conditions Credit Spread Index (FXI) is an extension of AXI which uses the same methodology but also includes transaction data for non-bank issuers scaling up the dollar volume covered transaction by a factor of nearly 500%. The resulting FXI spreads are highly correlated with AXI, especially over the past few years (Berndt, Duffie and Zhu, 2020). FXI is essentially the most robust credit sensitive index one could produce for the United States.
AXI will be helpful for the business loan market for those wishing to reference SOFR in their base rate —particularly multi-lender facilities, middle market loans, and trade finance loans—where transitioning from LIBOR to an overnight rate has been more difficult.
We’ve received strong market demand for AXI from a wide variety of financial institutions including regional banks, global investment banks, central banks, asset managers, insurers and some corporates.
Official sector engagement
Over the last few months, we’ve invested time in hosting education sessions with the Official Sector and market regulators including voting-member agencies of the Financial Stability Oversight Counsel (FSOC). This included but was not limited to meetings with the SEC, the OCC, the FDIC, the CFTC, the Federal Housing Finance Agency (FHFA), Consumer Financial Protection Bureau (CFPB), the independent member with insurance expertise and the United States Treasury. Upon AXI’s launch, we do not want anyone to be surprised.
The FSOC is charged with identifying risks to the financial stability of the United States; promoting market discipline; and responding to emerging risks to the stability of the United States’ financial system. We believe that the FSOC will continue to be an important forum for benchmark reform in the years ahead.
Regulators in both the United Kingdom and the United States have shared warnings about Credit Sensitive Rates (CSR’s). However, these concerns are by and large, applicable only to indexes that correlate highly with LIBOR and not to an approach like AXI, which is added to SOFR and references a larger and deeper pool of transactions Across-the-Curve.
In summary, concerns voiced by regulators generally center around three elements of CSR’s or spreads: First, that they lack the necessary volume of underlying transactions to be robustly determined. Second, that their robustness may be diminished in times in market stress. Third, that their robustness may not be sustainable over time due to changes in regulation or market structure. These concerns do not apply to a SOFR + AXI regime.
We have not received any objections from market regulators to AXI, nor have we received any concerns relating to the AXI methodology or the volume of underlying transactions.
Last week in remarks at the ISDA North America Conference, Nathaniel Wuerffel, Senior Vice President at the FRBNY shared his concerns with rates that “behave very similarly to LIBOR”. He said that “choosing reference rates only because of their similarity to LIBOR could very well end poorly” (Wuerffel, 2021). The fact that AXI does not correlate highly with LIBOR, and instead correlates highly with bank funding costs is a key differentiating feature of the index.
Turning to AXI conventions, we want to ensure AXI is as easy as possible for market participants to use. In general, AXI conventions for use in loans will align with existing industry standards. The AXI rate is known in advance of the interest period, much like it is for LIBOR-based loans today, and thus most of the loan conventions can mirror LIBOR and CME Term SOFR loan conventions. We’ve confirmed with major loan systems providers such as AFS that consuming more than one variable index to form the base rate for a loan is functionality that is currently supported.
We have published a number of materials on AXI. We set up a microsite on our website SOFR.org where market participants can register to receive updates. 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. After meeting with the CME’s Head of CME Benchmark & Index Services, Gavin Lee, and with the permission of the LSTA we published a draft CME Term SOFR + AXI concept credit agreement which contains clear fallback language and which Tess [Virmani] was kind enough to review. We also published a technical white paper and recorded a zoomcast with Meredith. Both are available on the LSTA website for members to download and view.
Although not required in the United States, we believe AXI will be best positioned for adoption within the institutional wholesale segment 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, compliance with IOSCO principles and European Union Benchmark regulation. So we held an RFP process with several potential administrators using the ARRC’s Term SOFR RFP as a guide. We expect to make a public announcement imminently on our selection and daily AXI beta rates will be published this month.
We expect new Benchmark Regulation in the United States in the not-too-distant future which we anticipate will equip the SEC with formal legislative power over benchmarks used in the United States. Given its construction methodology, AXI is well positioned to comply with this future regulation.
In conclusion, AXI is fundamentally 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 limited to the short-term markets that once underpinned LIBOR, (2) it is a credit spread add-on to SOFR, not a standalone rate and therefore promotes the adoption of SOFR (3) AXI automatically adapts to changes in bank funding composition, so its representativeness, robustness and alignment with IOSCO are sustained over time.
We are aware of some discussions regarding embedding a bank funding spread into the overall corporate margin on top of the base rate in loans. However, this spread historically added to LIBOR is reflective of the borrower’s credit worthiness. Changes to the spread over LIBOR are typically impacted by a change in the credit rating of the borrower.
The ARRC has recommended a historical spread adjustment for legacy contracts and our understanding is that the ARRC does not intend to recommend a forward-looking spread adjustment for new contracts. At this time there appears to be a lack of market consensus relating to a forward-looking credit sensitive spread adjustment and AXI’s launch will help to solve this problem. Referencing a robustly defined forward looking credit spread add-on to SOFR produced by an independent third party in a regulated environment will help provide market transparency and reduce associated conduct risks for lenders.
For lenders who wish to select SOFR as a based rate in their loans consistent with the guidance from the Official sector, but also wish to manage the risk associated with changes to their costs of funds, SOFR + AXI represents a sustainable, responsible and just option.
Thank you to the LSTA for opportunity to share these comments and I look forward to any questions.
Marcus Burnett is Chief Executive of SOFR Academy based in New York. For press enquiries please contact [email protected]. For questions on AXI please contact [email protected]. SOFR Academy Inc. is member organization of the Loan Syndications and Trading Association (LSTA), the Bankers Association for Finance and Trade (BAFT), the Asia Pacific Loan Market Association (APLMA), the International Swaps and Derivatives Association (ISDA), and is an Amazon Web Services partner institution. (1) Professor Darrell Duffie is not involved in the operationalization of AXI.