LCH to clear BSBY swaps from November 29

Addition of much-maligned benchmark follows methodology enhancements and jump in SOFR trading

LCH will begin clearing swaps linked to Bloomberg’s short-term bank yield index, or BSBY, on Monday, becoming the second central counterparty to handle derivatives on a rate which has attracted regulatory ire and which does not yet comply with UK benchmark rules.

“LCH will start clearing BSBY swaps from Monday 29 November 2021,” confirmed a spokesperson at LCH’s parent group, LSEG.  

The launch comes exactly two weeks after US competitor CME began clearing the instruments. Data from the Depository Trust & Clearing Corporation shows just one cleared BSBY trade so far, for total notional of just $3 million.

CME was unable to confirm the volume of cleared BSBY swaps by time of publication. Bloomberg declined to comment.

BSBY swaps began trading in April on a bilateral basis, yet volume has been patchy in the face of official sector hostility. A total of $5.75 billion notional has traded to date, according to DTCC data, representing 230 transactions.

 

US regulators have selected the secured overnight financing rate, or SOFR, as their preferred replacement for US Libor, which will cease after June 2023. Rising support for BSBY and other benchmarks that incorporate Libor’s inherent bank funding element has been met with anger among some regulators.

Securities and Exchange Commission chair Gary Gensler has argued that BSBY suffers from the same “inverted pyramid” problem as Libor, which saw more than $200 trillion of financial contracts globally priced off a relatively small base of unsecured interbank funding transactions. In September, he questioned the rate’s compliance with benchmark principles devised by international standard-setter Iosco.

The same month, the UK Financial Conduct Authority warned that fallback language contained in standard BSBY interest rate definitions penned by the International Swaps and Derivatives Association was too flimsy to comply with UK Benchmarks Regulation (BMR).

While Bloomberg certifies BSBY as compliant with Iosco standards – with third-party attestation from EY – the rate does not yet comply with UK BMR. This means it cannot be used in contracts by UK-regulated entities.

As of Monday, however, the contracts will be cleared by a UK-regulated CCP.

Speaking on a Risk.net panel earlier this month, Phil Whitehurst, LCH’s head of service development for the rates business, said the CCP aims to offer choice for those seeking an alternative to SOFR – which is now becoming established as the primary benchmark for US derivatives markets.

“It’s important to make sure you don’t accidentally end up with something that exposes you to credit sensitivity. Equally, if you want it and you deliberately seek it out, then it does seem reasonable that is also made available,” Whitehurst said.

Accelerated adoption of SOFR in derivatives markets and recent methodology changes aimed at enhancing BSBY resilience may help alleviate official sector concerns over the Bloomberg rate.

Regulators are keen to ensure the spread of BSBY doesn’t derail plans to make SOFR the market-standard rate to replace Libor. Whitehurst believes the Bloomberg rate will not “threaten SOFR as the mainstay”.

The so-called ‘SOFR First’ initiative, which flips interdealer quoting conventions to the risk-free rate, has swelled liquidity in SOFR swaps. In October, SOFR accounted for 16% of US dollar swap volume by DV01 – the sensitivity to a one basis point move in rates – up from 7.4% in July, according to data from Clarus Financial and Isda.

BSBY’s administrator is also addressing perceived shortcomings – most critically the rate’s ability to publish in times of stress, when underlying bank funding transactions can evaporate. Iosco warned in September that rates baring its hallmark must be resilient under all market conditions.

On November 15, Bloomberg expanded the waterfall of fallback inputs, which would apply in the event that underlying markets seize up. Under the original methodology, a three-day rolling window of transaction data could be expanded to five days to meet individual tenor thresholds. After this, the previous day’s rate would be repeated.

The upgraded methodology sees this repeated publication replaced by three additional steps. The first would expand each tenor bucket to include transaction data from neighbouring buckets. The second would use all available data across the curve.

In an October consultation, users broadly agreed with the proposals, but forced a rethink on the final step, known as ‘Level 6’. While Bloomberg planned to use the New York Fed’s overnight bank funding rate, or OBFR, as the fallback of last resort, users cautioned against relying on a rate built from similar data to the benchmark itself.

“Due to the overlap between OBFR’s underlying markets and BSBY’s underlying markets, this could increase the likelihood both rates might suffer from illiquidity at the same time,” Bloomberg stated in its consultation response.

Bloomberg has now inserted SOFR as the final fallback for the benchmark. This aligns with standard contractual fallbacks common to many BSBY cash and derivatives instruments, and may ease transition to safety-net rates embedded in transactions, users added. 

While enthusiasm for credit-sensitive rates has been dampened by the regulatory onslaught, and lending markets have begun to embrace SOFR in both overnight and term formats, participants believe BSBY and other alternatives have a role to play in the post-Libor world.

“The place where we’re likely to see more credit-sensitive rates emerge is in the bilateral space or the middle markets,” said Meredith Coffey, executive vice president at the Loan Syndications and Trading Association, speaking at a Risk.net Libor Countdown Clinic on November 24. “Those are places where the lenders aren’t necessarily the big money centre banks with the ability to fund themselves closer to SOFR, so I could see that being where there’s a gravitational pull to credit-sensitive rates,”

She adds the ability to use these rates will be contingent on banks meeting strict due diligence requirements demanded by regulators.

In a joint statement on October 20, US agencies instructed banks using alternative rates to demonstrate they are “appropriate for banks’ products, risk profiles, risk management capabilities, customer and funding needs, and operational capabilities”.

Editing by Alex Krohn