Markit plans SOFR credit spread add-on using CDS data

Vendor taps vast pool of credit market data to create new benchmark “not dissimilar” to Libor

IHS_Markit_London
IHS Markit's London headquarters

Another benchmark provider is vying to put its own spin on the secured overnight financing rate, the Federal Reserve’s preferred US dollar Libor replacement.

IHS Markit is developing a dynamic credit spread that can be bolted on to SOFR for dollar loans, Risk.net has learned – adding a third player to a field that already includes Ameribor and the Ice Bank Yield Index. 

According to four sources, Markit’s new benchmark will be constructed using its huge pool of proprietary credit reference data, including credit default swap and bond prices. Adding this dynamic credit spread to SOFR will produce a reference rate for loans that is “not dissimilar from Libor”, says a source with knowledge of the project.

“They’re the biggest provider of credit benchmarks, so it’s natural for them to be involved,” says a second source familiar with Markit’s plans. “It’s probably going to be a different methodology to others we’ve seen because they have that CDS data.”

A spokesperson for IHS Markit confirmed the company is “assessing the market need for this type of index” but declined to comment further.

Markit’s move comes amid growing concerns about the suitability of SOFR as a benchmark for loans. In a 2019 letter to regulators, a group of 10 US regional banks warned the new rate’s lack of credit sensitivity “will adversely affect credit availability” in periods of stress.

Interest paid on SOFR-linked loans could decline during such times, the banks argued, while the cost of funding will increase.        

In February, regulators including the Federal Reserve convened a new Credit Sensitivity Group to address those concerns. After an initial meeting on February 25, the group’s work was put on hold due to the coronavirus lockdowns, a Fed spokesperson confirmed.

The banks’ worst fears played out in March, when the spread between three-month Libor and SOFR instruments surged to 130 basis points, up from just 12.5bp a month earlier. At the same time, large corporates including Boeing, Ford and United Airlines tapped revolving credit facilities for billions of dollars. If these lines had been pegged to SOFR, returns on the loans would have fallen below the cost of funding. 

“There’s a good level of demand for an additional credit component to add on top of SOFR,” says the first source with knowledge of Markit’s project. “Clearly the basis between US dollar Libor and SOFR is huge at the moment, so it’s going to be interesting to see how that credit component discussion evolves.”

Three’s a crowd?

Markit is understood to be leaning heavily on its deep reservoir of CDS pricing data to construct its dynamic credit spread for SOFR loans. The firm collects over three million daily price quotes on more than 3,800 single-name CDS contracts for its CDX and iTraxx indexes.

Experts say Markit’s financials sub-index could be used as a proxy for bank funding costs, with corporate CDS sectors potentially layered over SOFR to more accurately match loan rates to the implied credit risk of the borrower. 

First, the firm must convince regulators and regional lenders that a CDS-based methodology is appropriate for a Main Street lending benchmark.

“If you look at who’s driving the motivation for a supplemental spread, it’s the US regional banks who are primarily servicing Main Street. A typical Main Street individual probably isn’t too familiar with a CDS product, so communicating how such a rate is produced, in a way that’s fair, consistent and reasonable, I think would be important,” says Marcus Burnett, director of SOFR Academy, an education and training firm.   

There’s a good level of demand for an additional credit component to add on top of SOFR
Source with knowledge of Markit’s project

Ameribor and the Ice Bank Yield Index are constructed from wholesale bank funding data. The BYI closely resembles Libor, particularly in shorter tenors. Published by the same firm responsible for Libor, Ice Benchmark Administration, it is built on much of the same data as the outgoing benchmark, including term deposits, commercial paper and certificates of deposit. However, the addition of secondary bond yields means the rate can spike higher than Libor in tenors from six months, as happened in March, according to a recent report from IBA. The BYI can be used as an add-on to SOFR or as stand-alone rate.

Ameribor, or the American interbank overnight rate, tracks overnight rates at Cboe’s American Financial Exchange, where 150 smaller regional US banks lend to each other.

Markit’s entry makes it all the more likely that multiple benchmarks and credit spread add-ons will be used alongside SOFR in the US loan market. 

“Clients are viewing the multi-rate environment as a certainty and setting up systems with the option to add a spread,” says Navin Rauniar, partner for Libor transition at consultancy TCS. “Because SOFR falls in a stress period, the marginal gains fall as well so need to cover your cost of capital and can only do that via a spread. What smaller players are looking for is simplicity in offering a rate to a client so they are looking at additional rates such as Ameribor and BYI, while the bigger players push for SOFR as it’s more familiar to them.”

Ameribor’s key selling point is that it is already compliant with the benchmark standards of the International Organization of Securities Commissions. The rate is also understood to be under consideration by the Financial Accounting Standards Board for benchmark status – a crucial requirement for hedge accounting.

To be Iosco compliant, benchmarks must be based on real transactions rather than “expert judgement” – the ultimate thorn in Libor’s side.

The overnight loans used to calculate Ameribor see around $2 billion in daily volume.

We know there are some big players out there who may be able to influence pricing because they’ve got very big CDS books
Marcus Burnett, SOFR Academy

With around $50 billion in contracts referencing the CDX investment grade index traded daily, according to data from the Depository Trust & Clearing Corporation, Markit’s benchmark should easily clear this bar.

However, single-name CDS contracts can be illiquid when markets are stressed, and some worry the concentration of activity at a few large banks means a single player could unduly influence pricing. 

“When you’re looking at benchmark quality, you’re first looking at the underlying volume of transactions and ensuring there’s a sufficient amount of transactions going through. You’re also ensuring that it’s free from subjective judgement. With CDS, we know there are some big players out there, mainly large global investment banks, who may be able to influence pricing because they’ve got very big CDS books,” says Burnett.

IBA has set a minimum volume target of $15 billion for the BYI, calculated on a rolling five-day basis. IBA says this was easily surpassed during the recent market turbulence. Over that period, Libor was based almost exclusively on expert judgement, according to the Bank of England’s May Financial Stability Report.

IBA aims to launch its benchmark officially in the second half of 2020, conditional on a sufficient number of banks providing primary market funding data to calculate the rate. Ameribor, which already lists weekly and quarterly futures on Cboe, plans to launch a one-month contract in June, from which the provider plans to build a forward-looking term structure.

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