Earlier this month, The Federal Reserve released a framework that would allow the creation of a term SOFR market based on SOFR futures. One of our milestone steps that were required before CenterState switches over to the Secured Overnight Financing Rate (SOFR) was a robust term market and creating a framework was the first step. In this article, we give an update on that SOFR term market, discuss the latest with the BYI Index and provide banks with an updated timetable.
The biggest issue that is preventing SOFR from replacing Libor at present is that there is no term market. That is to say, while SOFR is an overnight rate and there is a futures marketing with the overnight rate projected into the future, there is no liquid market or term projections passed about six months. That means you can’t use SOFR to hedge your balance sheet or a single loan that extends past August in maturity which is practically any asset you want to hedge.
Developing a term SOFR market would allow not only banks to hedge using SOFR but also banks to hedge in the future using SOFR which is our third and final milestone before SOFR can be adopted by banks. Since this will take some time, banks are likely more than a year away from seeing if a deep enough term market develops before deciding to adopt SOFR.
What About The BYI Rate?
In addition to term SOFR, we have been getting a slew of questions on the BYI Index. To catch you up to speed, the ICE Benchmark Administration (ICE), the same firm that is out of Atlanta that brings us LIBOR, introduced the “Bank Yield Index” (BYI) back in January. Similar to LIBOR, the BYI is an unsecured rate, reported by the same banks that compose LIBOR. Different than LIBOR, the BYI is based on actual transaction data instead of quoted rates of where banks MIGHT make a market.
Different from both LIBOR and SOFR, the BYI not only uses overnight banking lending in its index but augments that index with short-maturity, term bank debt transactions such as three-month Fed Funds, certificates of deposit, bank commercial paper and bank bonds. As expected, BYI tracks LIBOR and SOFR closely, but because it has more term transactions incorporated in its price compared to LIBOR and SOFR, the BYI Index is relatively volatile. This problem is further compounded as the methodology needs a certain number of data points which sometimes occurs over multiple days (instead of a single day) further adding noise to the calculation methodology.
What This Means For Your Bank
Our opinion is neither SOFR nor BYI is a suitable index right now to replace LIBOR when it comes to bank interest rate management. SOFR will likely get there as it has the support of the regulators and it is a true market-derived, risk-free market which could make it ideal for hedging. At the end of 2021, banks will no longer be compelled (but they are expected to continue) to report LIBOR and so that index might be in jeopardy. As such, all banks want to target the first quarter or second quarter of 2020 to decide on if they will switch to another index such as SOFR or BYI.
We will keep monitoring the respective markets and report back so stay tuned for important developments.
Submitted by Chris Nichols on March 25, 2019