Redefining credit-sensitive benchmark transparency. Increasing market confidence

The notional value of securities linked with USD London Interbank Offered Rate (LIBOR) was at its peak in 2012, when it reached the $200 trillion mark. Nevertheless, the LIBOR rigging scandal triggered a global overhaul of rate-setting mechanisms during the 2010s.
 
This overhaul led to the introduction of the Secured Overnight Financing Rate (SOFR), a risk-free rate which largely replaced USD LIBOR in 2021. SOFR was developed in compliance with the International Organization of Securities Commissions (IOSCO) Principles for Financial Benchmarks, leading to a successful transition.
 
However, one challenge persisted—the absence of a credit spread component, which had been crucial in the LIBOR benchmark. As a result, two credit-sensitive alternatives were developed: the American Interbank Offered Rate (Ameribor) and the Bloomberg Short-term Banking Yield Index (BSBY). Despite initial success, IOSCO determined that neither of these benchmarks complied with its principles, and BSBY is being discontinued.
 
In the post-LIBOR world, financial institutions searched for a reliable and robust benchmark that could account for the credit risks associated with unsecured bank-debt funding. Given this need, SOFR Academy, collaborating with a benchmark administrator, sought to create two complementary benchmarks—Across-the-Curve Credit Spread Index® (AXI)® and Financial Conditions Credit Spread Index® (FXI)®—that would serve as credit-sensitive additions to SOFR.
 
To gain market trust and regulatory compliance, SOFR Academy needed an independent review that could assess the benchmarks’ compliance with IOSCO principles. In particular, they needed to comply with IOSCO Principles 6 (benchmark design), 7 (data sufficiency), and 9 (transparency of determinations). Ameribor and BSBY did not meet these principles, which ultimately lead to their failure. And, if SOFR Academy failed to meet these principles concerning an index’s substance, it would likely require changing the index methodology rather than its governance.
 
Enter the IBM® Promontory® experts.

SOFR Academy engaged with IBM Promontory to conduct an in-depth evaluation of the AXI and FXI adherence to the IOSCO principles. During this assessment, five critical recommendations were made to enhance the benchmarks:

1. Clear fallback mechanisms.

Promontory identified that, while AXI and FXI had provisions for short-term technical issues, there was no clearly defined fallback for prolonged periods of unavailable data or low transaction volumes. In response, SOFR Academy introduced fallback methodologies within the AXI and FXI frameworks, that helped ensure the benchmarks’ reliability even during periods of market disruption.

For example, if data was unavailable or below thresholds for extended periods, AXI would default to FXI minus the five-year historical median of the difference between AXI and FXI.

2. Enhanced transparency in benchmark calculation.

To further align with Principle 9 (transparency of determinations), Promontory recommended improving transparency in the weighting approach for transaction data. So, SOFR Academy introduced detailed explanations within their methodology documents, explicitly defining how transaction volumes and maturity are used to calculate unscaled rates and average maturity. This allowed market participants to have clear insights into how daily benchmark rates are determined.

3. Introduction of monitoring framework for market conditions.

The Promontory review also identified potential market distortions if the benchmarks began to be widely referenced in financial contracts. To address this, SOFR Academy implemented a monitoring framework to track trading volumes and prevent the “inverted pyramid problem”, where trading volumes in products linked to the benchmark could significantly outweigh the transactions that inform the benchmark itself. This proactive governance helped AXI and FXI remain reflective of market conditions.

4. Detailed methodology for volume thresholds.

Promontory noted that, while volume thresholds were part of AXI and FXI, they were not clearly defined in the methodology. SOFR Academy responded by outlining specific transaction volume thresholds below which new daily rates would not be published. This helped AXI and FXI maintain accuracy and integrity by avoiding distortion from insufficient data.

5. Continuous review and adaptation.

SOFR Academy and its benchmark administrator introduced an annual review process to continuously monitor the benchmarks, aiming to keep them relevant and aligned with market conditions and regulatory requirements. This made it feasible for AXI and FXI to adapt as financial markets evolve, maintaining compliance and functionality.

After these enhancements, Promontory concluded that AXI and FXI had fully implemented IOSCO Principles 6, 7, and 9, relating to strength, transparency and reliability. AXI and FXI addressed the market demand for a credit-sensitive rate that complements SOFR with confidence.