Month: April 2019

EU Benchmark Regulations “representative” requirement

In a speech on 7/12/2018, the head of the British financial regulator, FCA (Financial Conduct Authority), Andrew Bailey, declared that the regulator could prohibit LIBOR from continuing to be used for new businesses, if it determines that LIBOR no longer sufficiently “represents” the market. (EU Benchmark Regulations, Article 11(1)(a): “[T]he input data [of a benchmark] shall be sufficient to represent accurately and reliably the market or economic reality that the benchmark is intended to measure.”) Such a determination might not have been overly difficult, if LIBOR had remained a poll-based benchmark. As Mr. Bailey asserted in the same speech, “[LIBOR] relies on the so-called judgment of the panel banks. […] [T]o continue in the new regulated world of benchmarks, LIBOR has to be representative. I struggle to see the case for this judgment.”

LIBOR, however, has evolved.

Reformed LIBOR and permissible “waterfall” input data

ICE, the administrator of LIBOR, has reformed LIBOR to incorporate a “waterfall” of input data types, including transactions, transaction-derived data, and expert judgments. (See here.) Moreover, the EU Benchmark Regulations explicitly permit an interest rate benchmark to incorporate these hybrid types of input data. (See table below.)

Determining “representative”

Since the EUBMR explicitly permit an interest rate benchmark to incorporate such “hybrid” input data types, the Reformed LIBOR can satisfy the “representative” requirements even if it incorporates non-transactional data (e.g., judgments). The question then is: How does one determine whether the Reformed LIBOR is “representative”? According to what criteria? What are the parameters and factors to be used?

The EUBMR do not provide a clear answer to these questions. However, logically such a determination may depend on the following factors, among others:
• Total number of input data;
• Total number of transactional data;
• Total number of judgments;
• Percentage of transactional data;
• Percentage of judgments;
• Variations in the numbers & percentages;
• Etc.

Recognizing the shrinking unsecured interbank funding markets, the Reformed LIBOR broadens the sources of its transaction data to include certificates of deposit and commercial papers. Whether the expansion in data sources will be sufficient to satisfy the “representative” requirements, however, remains uncertain.

ICE Bank Yield Index

In a clear effort to further expand the sources of transactional data, ICE created the Bank Yield Index (BYI) to supplement LIBOR as a credit-sensitive interest rate benchmark. According to ICE, BYI is derived from two types of input data:

1. Wholesale, primary market funding transactions executed by large, internationally active banks (e.g. inter-bank deposits, institutional certificates of deposit and commercial paper); and
2. Secondary market transactions in wholesale, unsecured bonds issued by large, internationally active banking groups.
   

Below figure shows the average numbers and volumes of transactions underlying BYI. (See here.)

Will these expanded data satisfy the “representative” requirements? The answer remains blowing in the wind! The regulators will eventually need to step up to resolve the issue.

[Update 4/13/2019: Last Wed, Randal Quarles, Vice Chair for Supervision of the Federal Reserve and Chair of the Financial Stability Board (“FSB”), gave a speech at an FSB roundtable on reforming interest rate benchmarks. On the topic of choosing a replacement rate, Mr. Quarles did not foreclose the adoption of rates different from SOFR (or other risk-free rates). Instead, he established the principle that banks should “conduct at least as much due diligence on the reference rates that they use as they conduct on the creditworthiness of the borrowers”. Mr. Quarles concluded that SOFR satisfied the due diligence requirements. However, the other benchmark rates (e.g., ICE BYI) may also satisfy the requirements, and thus be a potential candidate to replace LIBOR.]

IBA, the administrator of the ICE Bank Yield Index (“BYI”) (see here & here), may have gained some ground in promoting BYI as a replacement for LIBOR. According to ARRC meeting minutes and agenda, IBA has been scheduled to make a presentation to ARRC on BYI at the ARRC April meeting. The presentation supposedly was requested by ICE in response to comments on BYI made at the February ARRC meeting. However, the fact that ARRC specifically discussed BYI in its meeting seemed significant. Moreover, there have been claims (although unconfirmed) that large banks “don’t like SOFR” (see here), but instead endorse BYI (see here).

This development increases the chances that multiple benchmarks (e.g., BYI, AMERIBOR, etc), in addition to SOFR, may co-exist post-LIBOR, as I discussed previously here & here. That is, even if LIBOR is eventually phased out, it is increasingly likely that BYI and potentially other benchmarks administered by private parties may partly replace LIBOR, for example, for the cash markets, while SOFR is used for the derivative markets.

For the regulators, however, the co-existence of private benchmarks with SOFR raises the question of whether these private benchmarks are qualified to replace LIBOR, free from the issues that plagued and doomed the latter. For example, the regulators desire a transaction-based benchmark to replace LIBOR. But, what are the minimum number or volume of transactions underlying a benchmark that can pass muster with the regulators? SOFR has a trading volume of nearly $1 trillion across thousands of transactions each day. BYI, on the other hand, may cover less than $10 billion of daily transactions across less than 200 daily transactions. Moreover, these numbers are the totals over various tenors from 5 to 500 days. The respective number for each tenor will be even less. (See Figures 3, 4, & 5 of the ICE Bank Yield Index Update, here.) Are these numbers sufficient for a benchmark designed to replace the flawed LIBOR? If not, what are the minimum thresholds?

As a result, it is likely that the US regulators will eventually need to establish a set of protocols and procedures to control and manage the quality of the private benchmarks, similar to the EU Benchmark Regulations. The Congress, however, will first have to enact legislations authorizing the regulators to establish the regulations. The legislative and regulatory processes may be time-consuming and the outcome uncertain, adding to the uncertainties already embedded in the LIBOR-replacement undertaking!