FRA-OIS demise leaves hole in bank treasury risk management

Banks now face ‘greater downside’ to widening credit spreads

Credit: Risk.net montage

  • FRAs linked to Libor are – or were – widely used to hedge bank funding risk.
  • The transition away from US dollar Libor marks the end of FRAs, which are incompatible with compounded SOFR.
  • The Libor FRA market is already a shell of its former self: volumes fell 74% from 2019 to 2022.
  • Bankers say this makes it tricky to hedge against spikes in funding costs. “There is really no good way to protect yourself,” says one.
  • Possible alternatives include FRAs on BSBY or Ameribor, but banks are skeptical a viable market in these instruments will emerge anytime soon.

For years, a basis swap market known as FRA-OIS has served as a useful, reliable and liquid way for US bank treasury teams to manage their funding risk.

The package, a combination of a US dollar forward rate agreement (FRA) and an overnight index swap (OIS), captured the spread over the risk-free rate attributable to bank credit risk, which ultimately affects the cost of funding for dealers.

But the impending demise of US dollar Libor at the end of June has killed off this market, as FRAs cannot function using the new benchmark – a backwards-looking compounded version of the US secured overnight financing rate, or SOFR.

Banks will continue to borrow at rates akin to Libor even after the benchmark disappears, but as SOFR lacks Libor’s embedded credit spread, this has left treasurers without a crucial method of managing exposure to widening funding spreads. One treasurer at a European dealer in New York describes the demise of FRA-OIS as a matter of “very pertinent” concern.

Without the trade, banks face a “greater downside” to credit spreads widening, says the treasurer.

“If you had FRA-OIS basis swaps, you could really hedge using the same rate [at which] you were borrowing money,” he adds.

If the market does not have an ability to adequately hedge credit risk, there could be potential gaps and exposures. And this is when, perhaps, risk-free can be risky
Mark Cabana, Bank of America

Following the takeover of Credit Suisse and as the US regional banking crisis gathers steam, market participants now fear that treasurers have lost a key weapon in their arsenal during a period of greater stress on banks.

“In historical episodes, the FRA-OIS spread was a very clear place in the rates market to manage some of your stress-scenario exposure,” says the head of rates at one US bank. “We have a lot less [of those tools] available these days, so in these kinds of events, what does that mean for bank treasurers and for how people manage that sort of risk?”

While there is talk of using alternatives such as credit default swaps (CDSs), SOFR-OIS or credit-sensitive rates, market participants are sceptical that a true Libor equivalent will emerge to replace FRA-OIS as the risk-off trade of choice for banks.

“If the market does not have an ability to adequately hedge credit risk, there could be potential gaps and exposures. And this is when, perhaps, risk-free can be risky,” says Mark Cabana, head of US rates strategy at Bank of America.

Uprooted hedges

FRAs were a hugely popular instrument that functioned as a way to hedge a future Libor exposure, such as a new loan. If, for instance, a user was to take out a $1 million, 12-month loan in three months’ time, it would enter an FRA that would pay out the difference between 12-month Libor at inception and the rate at the time it took out the loan.

The OIS market uses the three-month federal funds rate as the benchmark, which represents the interest rate US commercial banks charge each other for uncollateralised loans of reserve balances held at the Fed. Fed funds is commonly seen as the main uncollateralised risk-free rate.

With the FRA market representing market expectations for uncollateralised bank credit risk via Libor, and the OIS swap market representing the uncollateralised risk-free rate, going long one and short the other in the FRA-OIS market was an ideal way to isolate bank credit risk from general underlying rate movements. As banks borrow at a spread above the risk-free rate linked to bank credit risk, FRA-OIS trades served as a handy hedge of rising funding costs.

But the phasing out of Libor from the end of June this year has killed off the FRA market, and the FRA-OIS market as a result.

When the cash payout is made after the three-month point in the example above, this is only possible with a forward-looking benchmark where the rate for the next 12 months is known in advance. If you use the replacement for Libor – backward-looking compounded SOFR – the user would have to wait until the very end of the period to calculate and receive any payout or charge, depending on rate movements.

With FRAs unable to work on backwards-compounded SOFR, the market declined significantly. According to the Bank for International Settlements, FRA volumes fell 74% between April 2019 and April 2022. With Libor cessation less than two months away, market sources say the FRA market is effectively dead already.

If everything is based off SOFR and there is no concept of FRA-OIS … then there is really no good way to protect yourself
Treasurer at a European bank

But although Libor will no longer exist as a credit-sensitive benchmark after June 30, banks will still lend each other money for short-term periods at a spread above the risk-free rate, equivalent to Libor. What they will lack is a liquid market in derivatives that can hedge the risk of interbank bank credit spreads widening.

“So, all of a sudden, if everything is based off SOFR and there is no concept of FRA-OIS … then there is really no good way to protect yourself,” explains the treasurer at the European dealer in New York.

“You’ve got your fundamental rate risk that you can swap out with SOFR, but the actual systemic credit and liquidity spreads, you really have no way to hedge it, so your ability to hedge your assets, your liabilities or your mismatches is just a lot lower. There is really no product for it,” he says.

While this has long been apparent, the issue came into sharp focus in recent weeks following the demise of Credit Suisse and the growing crisis enveloping US regional banks. While the absence of the FRA-OIS market makes it difficult to quantify the exact level of bank credit risk that is out there, anecdotally it has increased the pressure on funding costs.

It also comes during a period of extreme stress in the rates market. Yields on US Treasuries swung wildly in March, pushing the Ice Bofa Move index, which measures rates volatility, to highs last since at the nadir of the 2008 financial crisis.

On the morning of March 16, for the first time ever, CME Group even had to implement a circuit-breaker in SOFR interest rate futures because the price went through the threshold of 50 basis points in a single day.

A rates head at a second large dealer says the ability to trade FRA-OIS spreads is a safety valve for financial markets. He laments that such a barometer to measure stress in the banking system no longer exists and could even be contributing to the record levels of market volatility seen in March.

A bank treasury source at a second European bank, however, is not as exercised about the disappearance of FRA-OIS. He says banks now rarely fund at three- or six-month tenors due to the need to maintain metrics such as the net stable funding ratio – a regulatory measure that ensures banks have enough stable funding to cover the duration of their longer-term assets. Instead, they use more of a composite rate that blends a range of inputs, so the FRA-OIS hedge is less important than in the past.

He also notes that bank treasuries are not all alike, with some more exposed to a move in FRA-OIS-style spreads than others. French banks tend to have sticky deposits and are less exposed to funding risk, he says, whereas mortgage firms with an originate-to-distribute model are much more sensitive to credit spread changes and need to make much bigger use of hedges.

Pale imitations

So, the question is what other tools exist to hedge bank funding risk in a post-Libor world?

The European bank treasury source says bank CDS indexes like the iTraxx Senior Financials, which references single-name CDSs on 25 large European bank and insurance names, are still a viable hedge for bank credit risk.

But he acknowledges that the indexes aren’t ideal, especially given their potential to widen aggressively on little volume, as was seen with Deutsche Bank after Credit Suisse’s takeover by UBS, where small trades reportedly drove the subsequent blowout in the German bank’s spreads based on no new information.

“Unfortunately, they do not reflect funding risk, they reflect credit risk,” he says.

Bank of America’s Cabana, however, says using bank CDSs to hedge a widening of credit spreads is easier said than done.

“You can use the one-year CDS, but that is also not great because they are not particularly liquid and they have arguably more counterparty risk,” he says, referring to the fact that dealers selling bank CDS exposures may themselves not be around to pay out in an extreme crisis.

Two interdealer broker sources say they have seen an uptick in use of federal funds-versus-SOFR trades as an alternative to FRA-OIS. Instead of capturing term bank credit risk like FRA-OIS, this represents the unsecured lending premium over secured given SOFR is based on repo transactions, and at an overnight tenor instead of term.

But sources note that SOFR-OIS is not a good proxy for FRA-OIS, as it is at the mercy of other factors such as the risk appetite of the Federal Home Loan banks and the Fed’s reverse repo facilities.

This means it doesn’t necessarily do what a treasurer would want in a crisis. For instance, three-month fed funds swaps tend to trade above SOFR swaps at a one-year tenor, but as Silicon Valley Bank hit trouble in mid-March, the spread actually went negative (see chart) at a time when the cost of funds would have risen.

The disappearance of FRA-OIS has also restarted the conversation about credit-sensitive rates, which are based on real transactions and include a spread that represents bank credit risk. There have been several of these jockeying for position over the past few years, though the Federal Reserve has generally discouraged use of the rates while it tries to get the market focused on SOFR as Libor’s end date approaches.

In theory, futures or forward swaps based on the Bloomberg Short Term Bank Yield Index could be used to hedge against a deterioration in credit spreads. BSBY pulls in various types of short-term lending to global systemically important banks (G-Sibs), including commercial paper and corporate bonds.

But sources say BSBY suffers from a number of problems that make it unpalatable as a replacement for Libor in the immediate term. Firstly, it is thinly traded. Cash-settled three-month BSBY futures are exchange-traded on CME, but liquidity comes and goes in flurries. Just 10 trades took place on April 24, compared to 1,290 on April 10.

“If you really work for it, you can maybe find a relatively illiquid trade to do in BSBY,” says Bank of America’s Cabana.

The bank treasury manager at the European dealer in New York dismisses BSBY as simply “not liquid enough” to use as a hedge.

Secondly, regulators have openly criticised the benchmark. In 2021, the incoming Securities and Exchange Commission chair, Gary Gensler, launched an attack on the rate, saying it suffered from “many of the same flaws” as Libor.

Gensler argued that the underlying market of G-Sib interbank lending is too small to escape the so-called inverted pyramid dilemma, in which just a few transactions can have major ramifications for billions of dollars’ worth of securities and derivatives.

“The official sector has pushed back very hard against utilisation of BSBY, and there is really no alternative that is seen as a viable replacement,” says Cabana, pointing to Gensler’s comments.

The Bloomberg index, however, does respond rapidly to credit events.

The rate jumped during the start of the war in Ukraine last year, for instance. Short-term bank funding costs leapt after the Russian invasion on February 24, with three-month BSBY jumping from 0.18% at the start of January to around 0.87% on March 18.

SOFR stood steady at 0.05% from the end of October 2021 into early March 2022, even as Russian tanks began to roll towards Kiev. Fast forward a year, and three-month BSBY was trading at 4.88% on March 1, 2023, well above SOFR at 4.55%. The repo market rate also remained steady on March 13, the day after Silicon Valley Bank was taken over by the Federal Deposit Insurance Corporation, whereas three-month BSBY hit a then-record of 5.05%, according to figures from Bloomberg.

Nevertheless, bankers doubt a flourishing market in BSBY basis swaps will emerge any time soon.

“Very seldom have we seen banks use BSBY on balance sheet hedges,” says Isaac Wheeler, head of balance sheet strategy at Derivative Path, a provider of derivatives hedging services to US regional banks.

Asked if a BSBY-OIS basis swap market could be the answer, one head of US rates says that while as a trader he would like to see a more liquid market in credit-sensitive derivatives, he suspects regulators will continue to quash the rate’s prospects.

Finally, there is the Ameribor Benchmark Index Rate, which tracks lending between regional banks on the American Financial Exchange in Chicago.

On March 1, 2023, three-month Ameribor was trading at 5.2%, significantly higher than both BSBY and SOFR. The rolling 30-day average for the rate is roughly 5.1%. The benchmark’s inventor, Richard Sandor, says it is in a position to play a role in the post-Libor market.

“We are the credit spread for all banks, not just the big banks. Therefore, we are the best measure of the marginal cost of capital for all banks. So that makes us very different,” he says, adding that smaller banks are using Ameribor as a base rate to issue loans.

Cboe launched 30-day term Ameribor futures in September 2021, followed by the 90-day term equivalent in January 2022. But for the time being, Ameribor futures are little more than a gnat to the CME SOFR futures elephant in the rates market.

So far, there seems to be no real OTC market in Ameribor swaps – Derivative Path’s Wheeler is yet to see a single one.

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