To Note Or Not To Note – Promissory Note in Commercial Lending

[Note: This article was originally posted on July 9, 2021.]

“Undesirable” consequence of “confusion & doubt”

In 1976, a UK lawyer questioned the wisdom of the common practice in US to memorize a commercial lending transaction with both a loan agreement and a promissory note:[1]

“[M]any English lawyers regard them [American-style promissory notes] as undesirable. I think most English lawyers would advise strongly against the practice of setting out the obligations as between borrower and lender in two contemporaneous documents expressed in different terms. The opportunities for confusion and doubt and legal difficulty involved in such a practice are something which lawyers are – or ought to be – brought up to avoid.”

Given such an “undesirable” consequence of “confusion & doubt” by using a promissory note and a loan agreement “contemporaneously”, the question is whether it makes sense to continue this practice. To answer the question, it may be useful to find out why US adopted this practice in the first place.

Historical developments – divorce from UK practice

As the UK lawyer noted, because of the “undesirable” consequence associated with the use of “contemporaneous” documents in a transaction, in whole or in part[2], it appears UK bankers have historically avoided using promissory notes in commercial lending, relying instead on bills of exchange primarily.[3] In US, however, as the banking industry began to develop after the revolutionary war, the influence of UK banking practice began to wane, and promissory notes eventually replaced bills of exchange in commercial lending by the 100th birthday of the new nation. (See, eg, Summers, in Footnote 3. “[T]he bill of exchange, so prominent from Colonial times, slowly disappeared and was replaced by the promissory note as the most common credit instrument, a transition largely completed by the end of the Civil War”.)

So, why did US bankers & lawyers ignore the wisdom of their UK counterparts and preferred promissory notes over bills of exchange, in spite of the potential “confusion and doubt” (and any other potential disadvantages) arising from the use of two “contemporaneous” documents?

To answer the question, one NY lawyer proposed a few explanations, again in 1976.[4] First, UK imposed a stamp duty on promissory notes in 1782, which remained effective for almost 200 years. In US, on the other hand, stamp taxes for promissory notes were enacted as wartime emergency measures and repealed relatively quickly.[5] Second, as US became more mobile and less structured, borrowers could relocate to another state easily. US bankers might have preferred a simple piece of paper, without the need to produce the full bank records, to sue borrowers across state lines. Third, prior to the enactment of the Federal Reserve Act in 1913, there was uncertainty whether national banks in US had the corporate power to accept bills of exchange drawn on themselves. And fourth, habit. That is, the participants in US commercial lending – bankers, borrowers, bank regulators, judges, juries, etc – had been accustomed to promissory notes and found no compelling reasons to change.[6]

From the above historical analysis, it’s fair to conclude that the adoption of promissory notes in commercial lending in US served primarily as a substitute of the bills of exchange used in UK. However, in a typical promissory note, the obligor for payment (the borrower) is also a party to the loan agreement. The obligor for payment in a typical bill of exchange, on the other hand, is not the borrower, and therefore not a party to the loan agreement.[7] Therefore, replacing the bill of change by the promissory note results in the “undesirable” consequence of using “contemporaneous documents” in a transaction.

The next question then is whether, in the current environments, such an “undesirable” consequence (and any other additional disadvantages) may outweigh the benefits, if any, that promissory notes can provide, and thus whether it makes sense to continue to use promissory notes in conjunction with a loan agreement.

Modern analysis of pros & cons – noteless syndicated loans

Many commentators have analyzed the advantages & disadvantages of promissory notes under the modern-day legal frameworks for commercial lending in US. (See, eg, here, here, & Bellucci and McCluskey, The LSTA’s Complete Credit Agreement Guide (2nd ed. 2017), pp.200-203.) So, I will only briefly summarize the main points here.

In terms of the advantages of a promissory note, the main one is to “evidence” the associated loan. By my interpretation, this means the ability to show the world (ie, the borrower, regulators, courts, juries, third parties, …) the existence of the loan in a short, simple, and easy-to-understand document, in contrast with the lengthier and more complicated loan agreement. Additional notable advantages include negotiability[8], expedited court proceedings (mainly in NY[9] and some Latin America countries[10]), and the ability to pledge the note to the Federal Reserve at its discount window[11].

On the other hand, the disadvantages of a promissory note include difficulties in safekeeping and locating the note, the need to amend and re-issue the promissory note when the loan agreement is amended or when the loan principal amount changes under the existing loan agreement, the potential for inconsistencies between the promissory note and the loan agreement (as the UK lawyer noted), the additional work required to ensure consistency between the documents, and, particularly for syndicated loans, the logistic burdens created when a lender assigns all or part of its commitment (requiring collection of old notes to issue new notes).

It has been argued, however, that except for the “evidence” advantage, most of the other advantages offered by a promissory note are either not available (negotiability[12]) or can be accomplished by a loan agreement (expedited proceeding & pledge at Federal Reserve[13]) in most instances. This is particularly so for syndicated loans, which involve mostly sophisticated parties in complicated transactions, and the combined disadvantages of the promissory note outweigh its weakened advantages. As a result, in recent years, most syndicated loans have been “noteless”, making promissory notes optional by the request of individual lenders, and relying primarily on the loan agreements to memorize the transactions.[14]

Appropriate use of promissory notes – careful evaluation and practical expectation

Despite the “noteless” trend in syndicated loan transactions, not all commercial lending transactions need to forsake the promissory note. It may still be beneficial to have a short, simple, and easy-to-understand document to “evidence” the existence of the loan. Care & caution must be exercised, however, to reduce, minimize, or avoid the potential disadvantages embodied in the use of two “contemporaneous” documents in a single transaction.

First of all, the reality is a short and simple document, as desirable as it may be, cannot be expected to properly memorize a complicated transaction. This deficiency may be reflected on the availability of the NY expedited proceeding afforded to a promissory note. Under NY laws, the expedited proceeding may not be available to the lender if the promissory note and the loan agreement have become so “intertwined” at the time of breach.[15] Consider the case in Bonds Financial v. Kestrel Technologies[16]. There, the loan agreement of a resolving credit included events of default other than the failure to make payments. The borrower defaulted on a non-monetary term under the revolving loan agreement, which accelerated payment under the promissory note, and the lender instituted an expedited proceeding based on the promissory note. The court held that the expedited proceeding was not available pursuant to the promissory note, because it was necessary to reference an external document, the loan agreement, to determine whether an event of default had occurred.

Therefore, when structuring a loan transaction, the parties should carefully evaluate the interactions between the promissory note and the loan agreement (and other loan documents such as the mortgage[17]) and the potential of reduced or lost benefits from the promissory note, weigh the advantages and disadvantages afforded by using the note, and consider the option of a “noteless” loan transaction. This is particularly so when the promissory note references the loan agreement, which adds to the “intertwine-ness” between the documents (thus reducing the availability of the NY expedited proceeding) and also erodes the negotiability of the note.

In the minimum, a control clause should be included in both the promissory note and the loan agreement and specify which document should control in the event of inconsistencies.


[1] Richard G.A. Youard, Promissory Notes in International Loan Transactions: An English View, 4 INT’l Bus. LAW. 259 (1976).

[2] One author suggested that the UK stamp duty imposed on promissory notes in 1782 might have been another reason for the UK practice against promissory notes. Bruce W. Nichols, Some Observations on the American Approach to the Use of Notes in International Lending, 4 INT’l Bus. LAW. 239 (1976).

[3] See, e.g., Youard, supra; Nichols, id. (“English banks […] seem chiefly to have supplied credit by discounting bills of exchange held by customers, not the notes of such customers.”; Bruce J. Summers, Loan Commitments to Business in United States Banking History, Economic Review, vol. 61, September/October 1975, pp.15-23.

[4] Nichols, supra in Footnote 2.

[5] Florida currently imposes stamp taxes on promissory notes.

[6] The NY lawyer also suggested “transferability” of promissory notes (as opposed to loan agreements) as another reason for their continued use, particularly the ability to pledge promissory notes at the Federal Reserve. This reason, however, is now out of date, as most loan agreements are now transferrable, and the Federal Reserve currently accepts loan agreements as collateral. The latter subject will be discussed later in this article.

[7] In a typical bill of exchange associated with a trade, the seller (beneficiary) borrows from the seller bank (which may or may not be the drawee), which is documented by the loan agreement, while the buyer (drawer) orders the buyer bank to pay the seller (beneficiary), which is documented by the bill of exchange.

[8] Under UCC Article 3, an assignee of a “negotiable” instrument who qualifies as a “holder in due course” takes the instrument free and clear of most claims and defenses afforded to the maker of the instrument against the original holder. NY UCC 3-302 & 3-305. See also Footnote 12.

[9] NY CPLR 3213, titled “Motion for Summary Judgment in lieu of Complaint”, provides an expedited proceeding for enforcing an “instrument for the payment of money only”.

[10] See, eg, The LSTA’s Complete Credit Agreement Guide, supra at 201-202.

[11] The LSTA’s Complete Credit Agreement Guide, supra at 202.

[12] Under UCC Article 3, a “negotiable” instrument must include an unconditional promise or order to pay and all essential terms. NY UCC 3-104(1)(b). Most modern day promissory notes refer to the associated loan agreements and thus do not satisfy these requirements. See, eg, https://www.lewisrice.com/publications/noteworthy-should-lenders-use-promissory-notes.

[13] The Federal Reserve began to accept noteless loans as collateral in late 1990s. The LSTA’s Complete Credit Agreement Guide, supra at 202.

[14] The LSTA’s Complete Credit Agreement Guide, supra at 202-203. “[W]ith few exceptions [syndicated loan] lenders today no longer generally request promissory notes of the borrower”.

[15] Mlcoch v Smith, 173 AD2d 443, 444 (NY App Div. 2nd Dept. 1991). (“[T]he general rule is that the breach of a related contract cannot defeat a motion for summary judgment on an instrument for money only unless it can be shown that the contract and the instrument are “intertwined” and that the defenses alleged to exist create material issues of triable fact”.

[16] Bonds Financial, Inc. v. Kestrel Technologies, LLC, 48 AD 3d 230 (NY App Div. 1st Dept. 2008)

[17] In some states, a mortgage (or deed or deed of trust) must recite the amount of debt secured by the mortgage. If the mortgage references a promissory note, and the debt principal amount changes, a new note may need to be issued, and the mortgage will need to make sure to reference the correct note. See, https://www.linkedin.com/pulse/do-lenders-really-need-promissory-notes-anthony-cianciotti.

Hong Kong Sanctions Create Fissures Between US & Chinese Financial Systems – A Quagmire for Foreign Banks in US

[Update: The President said he had signed the Hong Kong Autonomy Act into law.]

Will the fissures turn into a gorge?

The question is whether the fissures may coalesce into a deep gorge dividing the financial systems of the 2 largest economies of the world.

Quagmire for financial institutions

Less than 2 weeks ago, on 7/2/2020, the US Congress unanimously passed the Hong Kong Autonomy Act (HKAA), which was the Congress’ response to the HK National Security Law (HKNSL) that the Chinese government enacted a few days prior on 6/30/2020 (see my previous post). The legislation should become a law soon, likely by midnight today.[1]

The HKAA generally will ban financial institutions (FIs)[2] from engaging in certain transactions with those foreign FIs (primarily Chinese FIs, but can be any non-US FIs) that have done “significant” businesses with certain sanctioned persons who have “materially” contributed to the erosion of autonomy in HK. (For more info about the definitions of the terms under HKAA, please see here.) To comply with such sanctions, however, a FI may run afoul of Article 29 of the HKNSL, which makes it a crime for any person (anyone in the world) to “conspire” with a foreign country to impose such sanctions. (See, also, here.) Hence, a FI can be penalized in US if it does not comply with US sanctions[3], but face the quagmire of being prosecuted in HK/China if it so complies.[4]

Picking side, US or China, but not both – a Hobson’s choice

For FIs currently having exposures in both US & HK/China, this quagmire may force them to decide whether to conduct business in either US or HK/China, but not both. For example, consider a Taiwanese bank (or a German, British, French, Canadian, Japanese, S Korean, Indonesian, Brazilian or any foreign bank) that conducts banking in both US and HK/China. If its HK/China operations are identified as having conducted significant transactions with sanctioned persons under HKAA, its US operations may be prohibited from engaging in transactions with its HK/China operations, or even with the bank headquarter. But, by complying with the US prohibitions, the US operations of the Taiwanese bank may be found to have violated Article 29 of the HKNSL, and hence the bank’s HK/China operations may be prosecuted, because both the US operations and the HK/China operations belong to the same bank. Under such circumstances, the Taiwanese bank may have no choice but to pick where it wants to do business in, either US, or HK/China, but not both.[5] That may be a Hobson’s choice that is not a choice at all.

An outlier black swan

In a US election year, and amidst the fallout from the COVID-19 pandemic, tensions between US and China have escalated. Financial sanctions such as the HKAA & national security laws such as the HKNSL are but a part of the complicated web of conflicts and brinkmanship involved in this new cold war. However, the Hobson’s choice facing down global financial institutions and the potentially unfathomable impact on the global financial systems may tamper the practical effects of these laws and orders.

For example, after the HKAA becomes law, the President has up to 120 days to identify the foreign financial institutions to be subject to sanctions, and up to 1 year to implement the sanctions. That means in the short run, no sanctions under HKAA will likely be enforced before the US election. After the US election, the political tensions may ease, allowing fine-tuning of the laws & regulations and their implementations, which may reduce the risks involved.

On the other hand, the severe erosion of HK autonomy and civil liberties under the HKNSL are frighteningly real for the people of HK. The prospect of great disruptions to the current financial systems arising from the US-China tensions, even if a low-probability outlier at this point, can also be real. It can be a black swan testing humanity’s ingenuity!


[1] The legislation has been sent to the President, who is required to sign the legislation within 10 days (except Sundays) or return it to the Congress. (“If any Bill shall not be returned by the President within ten Days (Sundays excepted) after it shall have been presented to him, the Same shall be a Law”, US Constitution, Article I, Section 8, Clause 2). If the president takes no action by the 10-days deadline, the legislation automatically becomes a law. On the other hand, if the President returns it, the Congress should have the 2/3 votes required to override the veto, required under the same Section of the Constitution.

[2] “Financial Institution” under HKAA has the same definition as in FDIC (31 USC 5312(a)(2)), which includes a broad spectrum of institutions, including insured banks, commercial banks or trust companies, securities brokers & dealers, foreign bank branches or agencies, etc.

[3] Violations of HKAA can carry civil penalties of the greater of $250k or twice the amount of transaction. Criminal penalties include fines up to $1m, or imprisonment for up to 20 years for a natural person, in addition to the fine. (50 USC 1705)

[4] Penalties under HKSNA generally implicate imprisonment of various terms, up to 10 years, and/or fines.

[5] It’s not clear whether compliance of sanctions by US subsidiaries of the Taiwanese bank (not branches or agencies) may subject the HK/China operations or the parent bank to prosecutions under HKNSA. However, because the US subsidiaries may be subject to the prosecution, meaning its personnel may be at risk if they enter the “influence zone” of HK/China, it will be difficult for the Taiwanese bank to communicate with and maintain control of the US subsidiaries, even if its HK/China operations and headquarter are not implicated.

LIBOR Replacement – Analyzing & Assessing Alternative Rates

NYDFS requirements

In December last year, the NYDFS (New York Department of Financial Services) required each of the regulated financial institutions supervised by NYDFS to submit a plan for addressing the LIBOR cessation and transition risks. Reflecting the urgency of the regulator’s concerns, the institutions were required to submit the plan within less than 2 months, by early February this year. (The deadline was later postponed by 45 days to late March.)

Specifically, NYDFS required the plan to include the following 5 items, without providing further details:

  1. Programs that would identify, measure, monitor and manage all financial and non-financial risks of transition;
  2. Processes for analyzing and assessing alternative rates, and the potential associated benefits and risks of such rates both for the institution and its customers and counterparties;
  3. Processes for communications with customers and counterparties;
  4. A process and plan for operational readiness, including related accounting, tax and reporting aspects of such transition; and
  5. The governance framework, including oversight by the board of directors, or the equivalent governing authority, of the regulated institutions.

Analyzing & assessing alternative rates – What is required?

Financial institutions subject to the requirements are likely scrambling to put together a LIBOR transition plan to meet the deadline. Toward this effort, the 2nd required item (“processes for analyzing & assessing alternative rates) seems to pose the lowest hurdle. After all, the ARRC (Alternative Reference Rates Committee), with the implicit approval & supports by the FRB, has chosen SOFR to replace LIBOR; more than $300b of cash instruments have been issued; the daily trading volumes of the SOFR futures contracts set a record, exceeding 80k contracts, recently; and LCH cleared more than $200b of SOFR swaps in January 2020. Moreover, Fannie Mae & Freddie Mac announced on 2/5 that they would no longer accept ARMs based on LIBOR by the end of 2020, and that they planned to begin accepting ARMs based on SOFR later in 2020.

Choosing SOFR, therefore, seems to be a path of the least resistance, particularly for budget-constrained institutions. In that case, the descriptions for item #2 should be simple and straightforward.

However, it is not clear at this point what additional information NYDFS will require for item #2 even if an institution simply decides to choose SOFR to replace LIBOR, as recommended by ARRP. Does the plan need to describe how the institution reached the decision to choose SOFR? Does the plan need to compare, analyze and assess the benefits & risks of other alternative rates? Does the institution need to discuss with its customers and counterparties and incorporate their positions and preferences into the analyses & assessments? Does the plan need to analyze and assess compliance with the 19 IOSCO principles?

Regardless of what the regulator(s) will specifically require in the LIBOR transition plan regarding alternative rates, and notwithstanding the fact that ARRC has recommended SOFR, it should be recognized that one size may not fit all. SOFR may not be the most appropriate replacement for LIBOR for some institutions, such as community and regional banks that depend substantially on unsecured funding. Furthermore, the regulator(s) may require an institution to develop and describe an independent and complete process & framework for analyzing and assessing alternative rates, even if the institution chooses SOFR to replace LIBOR. The spike in the repo market volatility in mid-September last year exemplified some of the shortcomings of SOFR, and demonstrated the need to be abreast of the pros & cons of other alternative rates.

Other alternative rates

If an institution desires or is required to analyze and assess alternative rates, what would be the right approach? In April last year, the Federal Reserve gave a broad-stroke clue that a bank should “conduct at least as much due diligence on the reference rates that they use as they conduct on the creditworthiness of the borrowers”.

To get started on this due diligence process, the table below lists information associated with some of the alternative rates. The information may be helpful to form the basis for developing a due diligence process to analyze and assess the alternative rates for replacing LIBOR, as required by NYDFS & FRB. Other currently available alternative rates not listed in the table include OIS, Effective Fed Funds, PRIME, Certificate of Deposit, Cost of Savings Index, etc.

Click image to view the full-sized table.

LIBOR Replacement – Determining Whether A Benchmark Is “Representative”

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.

Libor Replacement – ICE Bank Yield Index & Benchmark Regulations

[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!


LIBOR Replacement – The “Two Benchmark” Approach

BIS paper and “two-benchmark” approach

The March 2019 issue of the BIS Quarterly Review published a paper titled “Beyond LIBOR: a primer on the new reference rates”. (See here.) As its title suggests, the paper presents a non-technical introduction to new reference rates such as SOFR intended to replace LIBOR. What’s interesting about the paper is that it discusses a “two-benchmark” approach to replacing LIBOR. The approach entails the concurrent use of a risk-free benchmark rate and a credit-sensitive benchmark rate, and presents a potential solution to the “loss of credit premium” quagmire that I discussed in my previous posting (here).

Divergences between risk-free and credit-sensitve rates

As I discussed in my previous posting, SOFR, a risk-free rate, is not intended to fully replace LIBOR, which incorporates a term credit risk premium. A credit-sensitive benchmark rate may still be desirable, particularly for cash market participants.

The BIS paper recognizes this need for a credit-sensitive benchmark. In particular, the BIS paper illustrates the potentially significant divergences between a risk-free rate (eg, SOFR) and a counterpart risk-sensitive rate (eg, LIBOR) during both normal times and times of stress. The charts below from Graph 7 of the BIS paper compare the O/N LIBOR with SOFR in 2008, and the 3m GBP (British Pound Sterling) LIBOR with futures-linked SONIA in 2018. (Note: SONIA, “Sterling Overnight Interbank Average”, is an unsecured O/N money market wholesale rate, and the British equivalent of SOFR.)

The charts show that in 2008, the O/N LIBOR surged above 6%, while the SOFR rates plunged from above 1.5% to nearly 0%. Even in normal times, the 3m GBP LIBOR rose by ~10 bps at the end of 2018, while the 3m SONIA rates implied from futures contracts remained nearly unchanged.

Reformed LIBOR, LIBOR+

As a result of the potentially substantial divergences between risk-free and risk rates, I posited in my previous post that the cash market participants are left with 3 options, none of which is satisfactory: (1) Continue to use LIBOR; (2) Adopt SOFR + a fixed spread; and (3) Use other rates having a credit component, such as PRIME, FHLB, commercial paper, CD, AMERIBOR, ICE Bank Yield Index, new auction-based rates, Investment Grade SOFR, etc. The BIS paper, on the other hand, discusses another choice as a part of the “two-benchmark” approach. – A reformed LIBOR, or LIBOR+.

LIBOR+, was proposed in a 2014 report (here) prepared by the Market Participant Groups (MPG), which was established by the Financial Stability Board (FSB) to study the reforms of benchmark interest rates. The results of the MGP report was summarized by Duffie & Stein in 2015 (here), which was in turn referred to by the BIS paper with respect to the “two-benchmark” approach. According to Duffie & Stein, in essence, LIBOR+ broadens the sources of unsecured wholesale funding transactions to those between all counterparties (specifically CPs & CDs), in addition to inter-bank transactions. Broadening the sources can increase the number of transactions underlying the benchmark, and thus reduce the risks of manipulation. Additionally, an algorithm can be used to fix the LIBOR+ rates even if submissions from panel banks are insufficient, reducing the risks to financial stability. (For example, on any day t, if a bank does not have any available transaction, the algorithm can derive the rate for the specific bank by using the transactions in the previous t-k days, giving increasingly smaller weightings to days farther away in the past.)

“Two-benchmark” = RFR & LIBOR+

According to the BIS paper, many countries have opted for the “two-benchmark” approach by choosing a RFR complemented by a local LIBOR+. (“In Japan, the reformed TIBOR will coexist with TONA; and in the euro area, there is an ongoing effort to reform EURIBOR to complement ESTER.” “In Australia, the reformed BBSW [will complement] the O/N benchmark” rate. “In Canada, the liquidity under CDOR, which is based on the bankers’ acceptance market, had actually been on the rise […], making its retention as a credit-sensitive term benchmark that much easier.”) In US, such a “two-benchmark” approach means SOFR will co-exist with LIBOR+ (or other alternatives), with the risk-free SOFR being used primarily for derivatives or for securities issued by agencies or corporations, and the credit-sensitive LIBOR+ used primarily for other cash market products.

Uncertainties

Such a “two-benchmark” approach may cause fragmentation and segmentation in the interest rate markets, reducing liquidity, and causing confusions, among other potential issues and difficulties. Furthermore, it is uncertain whether LIBOR+ can pass muster with the markets or regulators, and whether other alternative credit-sensitive benchmark rates, such as ICE Bank Yield Index, may out-compete LIBOR+. Or, it is possible that markets may reject the “two-benchmark” approach and instead adopt SOFR + a fixed spread, if the SOFR market liquidity becomes attractive and the benefit of a single rate outweighs the lack of a credit premium. Only time will tell, although the clock may be ticking!!!

LIBOR Replacement – ARRC Weekly Office Hours

ARRC has been offering weekly office hours since March 1, 2019. The office hours are hosted by David Bowman, Senior Advisor at the Board of Governors of the Federal Reserve, every Fri afternoon 2-3pm, and open to the public. I listened in to the 3rd session last Fri, and found it quite informative.

To join the office hours, call 1-855-377-2663 for US callers, and +1 972-885-3168 for international callers. The participant code is 09823427.

For more info, visit the ARRC announcement here.

LIBOR Replacement – The loss of market-based credit premium and the quagmire for cash market participants

It has been widely reported that the Federal Reserve (via a group of public & private organizations, ARRC) has identified SOFR (Secured Overnight Financing Rate) to replace LIBOR. SOFR, however, is a risk-free (or nearly risk-free) rate and does not include risk premia such as the credit risk premium. Therefore, SOFR cannot fully replace LIBOR for many stakeholders, particularly those in the cash markets.

Need for a rate with credit risk

In 2014, the FSB (Financial Stability Board) issued a report titled “Reforming Major Interest Rate Benchmarks”. (Available here.) In the report, the FSB pointed out that LIBOR, which is based on unsecured interbank markets, included two main components, a “risk-free or nearly risk-free rate” and a group of other “risk premia, including a term premium, a liquidity premium, a credit risk premium as well as potentially a premium for obtaining term funding”. The FSB report observed that it might be feasible for many derivative transactions to replace LIBOR with a risk-free rate, such as SOFR. However, the FSB report also pointed out that there would be continued need for a “reference rate with bank credit risk”, such as in the markets for bank loans, and other “bank-provided credit products”. In general, there is a greater need for such types of risk premium in the cash markets, such as bank loans, FRN bonds & securities, mortgages, structured products, capital market products, etc.

Nonexistence of a market-based rate with credit risk

Unfortunately, the need for a market-based rate with bank credit risk to replace LIBOR cannot be readily and satisfactorily met in any existing markets. In a speech presented on 7/12/2018, Andrew Baily, the head of the British financial regulator, put it bluntly: “It is difficult […] to see how the term credit premium that LIBOR seeks to measure […] can be obtained from other sources. We have not seen a compelling answer to how one-month, three-month, six-month and twelve-month term bank credit spread can be reliably measured on a dynamic and daily basis.” (See here.)

The quagmire for cash market participants

In 2014, the FSB envisioned a post-LIBOR new world, where multiple rates would provide the flexibility to meet the needs of multiple market sectors. A few years later, the reality has sunken in that the existing market liquidity can only support a risk-free rate, SOFR, but not a rate with credit risk. Therefore, for cash market participants, the new post-LIBOR reality is not a world of multiple rates to choose from, but one in which no single existing rate is satisfactory for their needs.

No satisfactory options

Given such a quagmire, cash market participants face enormous difficulties in planning for the anticipated changes in LIBOR. No options currently available paint a clear path.

  • Continue to use LIBOR: And face the liability and legal risks that LIBOR may be held inadequate or even illegal, particularly with the prospect of new bench mark regulations such as the EU Benchmark Regulations.
  • Adopt SOFR plus a fixed spread: And face the risks of mismatch between assets and liability due to large fluctuations in the credit spread (in addition to the lack of term structure and other deficiencies of SOFR).
  • Use other rates having a credit component, such as PRIME, FHLB rates (eg, 11th District Cost of Fund), commercial paper rates, CD rates, AMERIBOR (here), ICE Bank Yield Index (here), new auction-based rates (here), Investment Grade SOFR (here), etc: And face the reality that all these markets have low liquidity and other deficiencies such as data transparency & sufficiency, and may not be acceptable as a benchmark rate.

The risks

For cash market participants who are regulated, such as banks or insurance companies, the question is how the regulators will approach this quagmire. Will they establish a safe harbor or other rules? Or will they leave it to the regulated entities to establish their own safety and soundness policies & procedures? Considering the costs and uncertainties, it is most likely these regulated entities will not make any major decisions and take major actions until the regulators provide a clear guidance. The risk is high, however, that those decisions & actions may be too late.

Financial Software Patents and “Abstract Idea” – Focus on Technology, Not Merely Finance

The laws concerning patent eligibility for software inventions, including financial software inventions, and the concept of “abstract idea” have undergone sea changes in recent years. These changes were meant to weed out overly broad patents, but have inevitably limited or muddled the scope of patent eligibility for software inventions. In light of these changes, inventors of financial software inventions interested in seeking patent protections should not focus merely on the finance ideas, even if they are considered highly innovative, but should also focus on the implementing technology, including both software and hardware.

Software and abstract ideas

Software inventions, particularly those implemented on general-purpose computers, face an additional hurdle to be patent eligible, when compared to the other types of inventions. – Software must not be considered an “abstract idea”, which is not eligible for patent protections even if it satisfies the other patentability requirements. This is because software inventions include primarily “methods and steps” in performing a set of logical operations, which are often described and controlled solely in a high-level programming language detached from the inner working of the general-purpose computer. Such “high-level” operations of software inventions may encroach on the domains of “abstract ideas”, which are considered too fundamental and basic to human societies and activities for any one individual to monopolize by patents, even for a limited period of time.

Examples in financial software: hedging commodity transactions; reducing settlement risks

Financial software inventions are particularly susceptible to the “abstract idea” hurdle, because inventors often focus on the finance or business ideas, giving little consideration of their practical implementations, as software or otherwise. For example, in 2010, the US Supreme Court in the case Bilsky v. Kappo held that methods and software for hedging commodity transactions were “abstract ideas” and not patent eligible. Subsequently, in 2014, the Supreme Court held that methods and software for reducing settlement risks by using a computer as a third party intermediary were patent-ineligible “abstract ideas”, in the case Alice v. CLS Bank.

Unclear definition of “abstract idea”

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Puzzling Definition of “Time Deposit”

IN MEMORY OF THE 6/4/1989 TIANANMAN SQUARE MASSACRE.

Reg. D Definition of “Time Deposit”

Regulation D (12 CFR 204) promulgated by the Federal Reserve Board (FRB) imposes reserve requirements on certain bank deposits. Generally, “transaction accounts” are subject to reserve requirements, but “time deposits” and “savings deposits” are not. The current definition of the term “Time Deposit”, however, can be confusing if not read in light of the historical context. Currently, Reg. D defines a “Time Deposit” as:

Time Deposit means:

(i) A deposit that the depositor does not have a right and is not permitted to make withdrawals from within six days after the date of deposit unless the deposit is subject to an early withdrawal penalty […];

(ii) A savings deposit;

(iii) […]

(iv) […]

37 CFR 204.2(c)(1).

Based on the above definition, therefore, “Savings Deposits” are a type of “Time Deposits”. But why?

If one reads the definition of “Savings Deposit” in the regulation, a “Savings Deposit” does not require a minimum term or impose an early withdrawal penalty. It is thus substantially different from the type of “Time Deposits” defined in the first sub-part of the “Time Deposit” definition.

Moreover, in practice, “Savings Deposits” are generally understood as a different type of deposit accounts from “Time Deposits”. For example, in the Federal Reserve Form, FR 2900 (Report of Transaction Accounts, Other Deposits, and Vault Cash), with which financial institutions report their deposit liabilities for reserve reporting purposes, “Time Deposits” and “Savings Deposits” are listed as two separate categories, apart from “Transaction Accounts” and “Vault Cash”. Additionally, the Reg. D section of the FRB Consumer Compliance Handbook also lists “Time Deposits” and “Savings Deposits” as two separate and distinct categories.

Under Reg. D, both “Time Deposits” and “Savings Deposits” are explicitly exempted from the reserve requirements. Therefore, it is not necessary to define “Savings Deposits” as a type of “Time Deposits” to achieve the goals of the regulation. — It is a puzzling definition, until one looks up the history of the regulation.

History

As first written in 1980, Reg. D defined a “Time Deposit” as one that “does not have a right to withdraw” for 14 days after deposit. Notably, the definition at the time did not explicitly impose an early withdrawal penalty. Such a definition, therefore, was broad enough to include certain “Savings Deposits”, for which the bank reserved rights to require an early withdrawal notice. Therefore, it was logical for the 1980 version of Reg. D to define “Time Deposits” to include those “Savings Deposits” that were not considered “Transaction Accounts”. Specifically, the definition was written as follows:

Time Deposit means:

(i) A deposit that the depositor does not have a right to withdrawals for a period of 14 days or more after the date of deposit. “Time deposit” includes funds:

(A) […];

(B) […];

(C) […];

(D) […];

(E) That constitute a “savings deposit” which is not regarded as a “transaction account.”

(ii) […].

45 Fed. Reg. 56018, 56020 (August 22, 1980).

By comparing the 1980 and current definitions, it becomes clear that after the definition of “Time Deposits” was amended, particularly by adding the early withdrawal penalty, “Savings Deposits” no longer belonged in the conventional type of “Time Deposits” and were removed from the explicit list. For unknown reasons, however, the FRB decided to keep it as a separate category under “Time Deposits”, thus creating the present confusions.

To clarify, FRB should amend Reg. D to remove the “Savings Deposit” from the definition of a “Time Deposit”.