The views and opinions expressed in this article are those of the thought leader as an individual, and are not attributed to CeFPro or any particular organization.
By Bryan Greathouse, Chief Investment Officer, Centennial Bank
Can you provide a brief overview of your views of alternative rates that are emerging amidst market hesitation towards SOFR?
Several alternative rates have emerged, and continue to develop, as viable options to SOFR. Many market participants are hesitant towards SOFR due to the lack of an imbedded credit component in addition to the Fed having complete control on SOFR. These concerns are certainly warranted and can be easily illustrated by the divergence between LIBOR and SOFR during the onset of the COVID-19 pandemic when SOFR effectively dropped to zero and 1-month LIBOR increased more than 40 basis points. Rates such as AMERIBOR, Bloomberg Short Term Bank Yield Index (BSBY), U.S. Dollar ICE Bank Yield Index, and IHS Markit U.S. Dollar Credit Inclusive Term Rate (CRITR) are among the more notable alternatives similar to LIBOR. More traditional alternatives consist of Prime and weighted average or compounded Effective Federal Funds Rate (EFFR). In my opinion, multiple options are good for market participants; although, it does present challenges from a risk management standpoint.
Currently, SOFR provides the deepest and most liquid market with respect to rates vying to replace LIBOR. While rates such as AMERIBOR and BSBY are appealing to many financial institutions, derivatives markets are currently in infancy, or not yet tradable. Correlations between EFFR and AMERIBOR or BSBY are fairly strong over longer periods of time, thus providing a potential option to manage risk through derivatives. However, it would induce some level of basis risk that, while likely immaterial from a long run perspective, could produce ineffective hedging strategies at times. For AMERIBOR, BSBY, or any other “LIBOR like” alternative rate to truly compete with SOFR, deeper, more liquid markets that are proven to hold up reasonably during periods of stress will need to be developed.