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.


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”

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

The Pros & Cons of Patents

A patent grants an inventor the rights to exclude others from making & using the invention for 20 years. Patents are critical in protecting the intellectual efforts of inventors, and thus in encouraging and promoting inventions. Such a 20 year monopoly, however, may impose disproportionately high social costs, particularly because the patenting mechanisms are often imperfect and may be abused. In addition, in the information age, where economical & commercial activities transact in a much faster pace than in the industrial age, the values of patents and thus the incentives they provide are often insufficient to justify the associated costs.

To better appreciate the roles of the patent system in the information age, I have discussed generally some of its pros & cons in this posting. Hopefully, I’ll be able to elaborate on some of the specific points in future postings.


  • Provide incentives to invent: This is the primary goal of patents, explicitly authorized by the US Constitution to “promote the progress of science and useful arts”. Because of the high upfront costs to obtain patents and the uncertain returns on the investments, however, the incentives can be weak. (In the finance parlance, the present value of potential future cash flows from a patent is very small, because the discount rate applicable to the cash flows needs to be high enough to adequately factor in the high uncertainty in rewards. See, “Fixing Patent Boundaries” by Tun-Jen Chiang, accessible here.)
  • Encourage invention disclosure: An inventor may not have to disclose her inventions, if it’s viable to keep them as trade secrets. Invention disclosure, however, benefits the society by allowing others access to the invention. Therefore, called the “patent bargain”, an inventor is awarded a 20 year patent monopoly in exchange for disclosing her invention. For the information industries (ie, software), it is generally difficult to reverse engineer a software and thus feasible to effectively maintain trade secrets. (See, eg, here.) The flip side of the coin is that it will be difficult or costly for a software patent holder to detect infringements of the software invention, deterring inventors from seeking patent protections. The patent bargain therefore may not be sufficient to effectively encourage disclosure in the software industries.

Continue reading “The Pros & Cons of Patents”

Puzzling Definition of “Time Deposit”


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.


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”.

Syndicated Loan Participant Due Diligence

Insufficient Due Diligence

The syndicated loan markets have expanded steadily in recent years, reaching a record of more than $2.5T in US total issuance in 2017, surpassing the previous record of $2.14T set in 2013. ( As the markets expand, more and more lenders, particularly smaller banks or non-bank institutions, are able to diversify exposures with reduced efforts, by delegating some of the works required for originating loans to the lead agent banks.

In this process, however, due diligence by participating lenders, and hence their risk assessments, may suffer. In some instances, it may be appropriate to assign lower risks to syndicated loans, particularly larger ones extended to large public corporations, and adjust the due diligence accordingly. In some other cases, nonetheless, due diligence may not be sufficient, because there is insufficient public information about the borrower, and the lender does not have sufficient manpower or resources to conduct adequate due diligence, resulting in misjudgments of the risks involved.

Additionally, a participating bank may trust that the lead agent bank will conduct the syndication competently and disclose all relevant information in good faith, or risk damaging its reputation. If this trust is misplaced, however, the participating bank may find it difficult to obtain appropriate legal recourses.

Arm’s Length Dealing

First of all, most syndicated loan agreements explicitly provide that the lead agent bank is not a fiduciary for the participating lender, and that the participating lender has conducted its own credit analysis based on appropriate information, not relying on the lead agent bank. (Eg, “The LSTA’s Complete Credit Agreement Guide”, by Bellucci & McCluskey, 2016; JPMorgan Chase v. Luxor Capital, Supreme Court of NY, NY County, 2010.) Moreover, in NY, syndicated loan dealings generally are considered arm’s length transactions between the lenders, and the lead agent bank does not owe a fiduciary duty to the participating banks.

For example, in Banque Arabe et Internationale E’Investissement v. Maryland National Bank (US Court of Appeals, 2nd Cir. 1995), Maryland National Bank originated a $35m loan for conversion of rental buildings to coops or condos, and sold $10m of the loan to Banque. The borrower eventually defaulted, because the NY regulators delayed in approving any of the conversions, and Banque sued Maryland National Bank for failing to disclose the delays in regulatory approval. The Court held that “[i]n the case of arm’s length negotiations or transactions between sophisticated financial institutions, no extra-contractual duty of disclosure exits. […] This same principle applies to loan participation agreements, in which there is deemed to be no fiduciary relationship unless expressly and unequivocally created by contract.”

That being said, all parties to the loan syndicate, including the lead agent bank, are bound by the covenant of good faith and fair dealing. Also, if the lead agent bank possesses “superior knowledge” of matters not readily available to the other parties, or if it needs to complete or clarify partial or ambiguous statement previously made, the lead agent bank may have duty to disclose the information. Otherwise, the lead agent bank may be subject to claims of fraud. (Eg, Banque Arabe et Internationale E’Investissement v. Maryland National Bank.) The parties can also negotiate for specific disclosures by the lead agent bank and incorporate them into the agreement. These remedies, however, may not be generally available and need to be decided on a case-by-case basis.

Best Practice

Addressing multibank lending transactions, OCC has advised participating banks to conduct independent credit analysis, to require the borrower to make full credit information available, and to require the lead agent bank (or the selling bank) to provide available information on the borrower, among others. (OCC Banking Circular 181 (Rev.), “Purchases of Loans in Whole or in Part-Participations”, August 2, 1984.) Sufficient due diligence is always the best policy, be it a syndicated or participant loan.