September 18, 2023

In the Wake of Libor, New AFX Leadership Turns Attention to Growth

The formal cessation of the Libor benchmark at the end of June was long anticipated by, among others, the American Financial Exchange (AFX), the platform on which funding transactions among its mostly regional-bank membership set the Ameribor rate.

Ameribor is designed to be credit-sensitive like Libor while better reflecting banks’ funding costs than does the Secured Overnight Financing Rate (SOFR), which was developed by the Alternative Reference Rates Committee with the participation of the biggest U.S. financial institutions.

AFX is recovering from volume declines early in the pandemic period and in the wake of this year’s bank failures – both Silicon Valley Bank and Signature Bank were members. Average daily volume (ADV), which approached $3 billion in March and April 2022, was $1.9 billion in the third quarter of 2022. The $1.5 billion on August 8 this year was five times the May 1 figure.

AFX was acquired in April by 7RIDGE, a fintech-specializing growth equity fund founded by former Deutsche Börse chief executive Carsten Kengeter. On May 2, John Shay was announced as AFX’s new CEO, succeeding its founder, the longtime financial markets innovator Richard L. Sandor.

In an interview, Shay said commercial agreements with “very large deposit partners,” whom he was not yet at liberty to disclose, could quickly move ADV to $10 billion and as high as $50 billion. He hopes to grow AFX from 275 bank-client members to more than 800 banks with over $1 billion in assets, “and we’d love to sell as many trademarks and data licenses as possible,” to compete with the likes of SOFR.

The prospective new participants “understand how being part” of this platform that determines a credit-sensitive rate (CSR) “helps their legacy franchise value,” said Shay, who had a 25-year career with interdealer brokerage ICAP. His other positions included serving as adviser to the CEO of Virtu Financial, founder and managing partner of Capital Market Services Inc., and chairman of post-trade servicer Acadia, now part of London Stock Exchange Group.

A Regulatory Caveat

July 3 statement from the International Organization of Securities Commissions (IOSCO) threw a curve at AFX, citing “regulatory authorities’ concerns that certain CSRs currently in use exhibit some of the same inherent ‘inverted pyramid’ weaknesses as Libor” and if not modified could threaten market integrity and financial stability.

That came as a surprise to Shay and AFX, whose auditors had deemed it compliant with IOSCO’s principles for financial benchmarks.

IOSCO’s concern is with reliance on bank-issued commercial paper (CP) and certificates of deposit (CD), and specifically the depth and reliability of those markets. It said that “gaps in data and volatility related to reliance on a very small number of transactions mean that USD Libor alternatives based on these markets are unlikely to sufficiently implement” the principles relating to benchmark design.

Shay defended the fact that Ameribor’s term rate is generated from CP and CD data, “a great source of executable data for developing a term structure,” but daily Ameribor is derived from unsecured funding transactions reflecting banks’ actual costs. AFX’s volume is currently a tiny fraction of the overnight repo market’s, and growing it to tens of billions of notional value should enable AFX to further develop its listed futures market and an over-the-counter swap market “devoid of manipulation,” Shay said.

IOSCO also expressed concern about the use of term SOFR rates exceeding the volume of SOFR derivatives transactions on which term SOFR is based. It considered SOFR “somewhat better placed among rates reviewed, but still fell short of [daily] SOFR” as a floating-rate benchmark.

“AFX is working diligently to address IOSCO’s newly raised concerns regarding Ameribor’s compliance with three of their 19 principles,” the company said in a July 10 statement, “and is confident in our ability to sufficiently address them based on the recommendations that AFX received from IOSCO.”

Performance Under Stress

IOSCO did not address an issue that has been raised by U.S. regional banks about the SOFR secured rate falling during periods of market stress when banks’ funding costs rise. An unsecured CSR should instead increase, resulting in revenues from loan assets rising alongside liabilities and reducing balance-sheet risk.

A December 2022 Federal Reserve Bank of New York staff report concluded that risk could reduce regional banks’ incentive to lend during periods of stress, or increase credit pricing throughout the cycle.

After Silicon Valley Bank went into receivership, Shay said, SOFR dropped by 3 basis points, and Ameribor moved up by 50.

“That event defined perfectly the risk-free rate, which should have incredibly low volatility because it’s the borrowing rate of the government,” Shay said. “Borrowing rates went up for my clients, which represent the super majority of banks in the U.S.”

He added that Ameribor typically trades at 20 basis points over SOFR and about 9 basis points over Bloomberg’s credit-sensitive BSBY.

Ability to Choose

“We’re reflecting true, observable credit-rate transactions, and that spread is worth a lot to those banks,” Shay said, adding that AFX is not seeking to replace SOFR, but rather cleave off 5% to 10% of the market.

The IOSCO statement echoes federal regulators regarding term SOFR and the CSRs. Still, Congress made clear in the Adjustable Interest Rate (Libor) Act of 2021 that lenders can choose Libor replacements other than SOFR.

Ameribor futures are Cboe-listed, indicating compliance with current regulations of the Commodity Futures Trading Commission.

Regulators will nonetheless want to know why a bank sees a non-SOFR rate as appropriate, said Fried, Frank, Harris, Shriver & Jacobson partner Nihal Patel. That could entail disclosures around the risks of a given CSR, along with who the users are and their understanding of the risks.

In a Fried Frank Regulatory Intelligence posting, Patel called the IOSCO statement “bad news” for CSR users but pointed out that the global organization “does not have the power of direct regulatory oversight,” which falls to authorities in the member jurisdictions.

FSB Reinforcement

In late July, in Final Reflections on the Libor Transition, the Financial Stability Board said it “welcome[d] IOSCO’s review of these rates and supports and underscores IOSCO’s message that ‘market participants should proceed with caution if they are considering using CSRs and take into account the risks identified in the review.’”

A regional bank executive and supporter of AFX, who asked not to be identified because he did not have authorization from his superiors, said he believed both Ameribor and BSBY would endure despite such statements because of demand for them in the cash market and the fact that the CSRs had established themselves before the IOSCO document’s release.

“We just went through a banking crisis,” the banker said, “and BSBY and Ameribor performed as expected. If that doesn’t say they are viable, then what does?”

Bloomberg Index Services Ltd. opened a month-long consultation review, through October 13, on a proposal that could lead to future cessation of “the publication of the BSBY index as a benchmark . . . BSBY’s usage within financial products is limited and unlikely to see significant growth, resulting in insufficient usage of the benchmark,” the Bloomberg document said.

Shay at AFX commented: “AFX and its members firmly believe there is a need for a credit-sensitive rate. We will continue down our path of supporting our robust underlying cash market that will eventually incorporate partner term structures that will be useful in determining a forward-looking credit-based benchmark.”