Odd Lots - The Case for AMERIBOR As The Replacement for LIBOR

Episode Date: June 3, 2020

Welcome to Part III of the Odd Lots LIBOR series, in which Tracy Alloway and Joe Weisenthal take a look at life after LIBOR, the interest rate tied to more than $350 trillion worth of financial assets.SOFR is the Federal Reserve’s preferred replacement for LIBOR, but it’s not the only alternative reference rate around. On the third episode of the series, we speak with Richard Sandor, a serial innovator in financial markets, and the CEO at American Financial Exchange. He explains why he thinks his own proposed rate, called AMERIBOR, could be a suitable benchmark and replacement for Libor.See omnystudio.com/listener for privacy information.

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And I'm Joe Wisenthal. So Joe, this is the third episode of our LIBOR series. You know, I said it in the beginning and I wasn't being facetious. This is one of those things that I felt was extremely important to understand that I didn't have much knowledge on. And so I'm very happy that we finally working through all that. You know, our first episode, we sort of talked about the problems with LIBOR pre-financial crisis and post-financial crisis. And then in the second episode, we talked a lot about the transition away from LIBOR and how that's going.

In this episode, we are going to talk to someone who's actually actively trying to come up with an alternative reference rate. It is interesting because I know that there is a very big push afoot to move, you know, as we've talked about, from LIBOR over to SOFER, and there are all kinds of efforts going on towards that front. But I guess that is not the only theoretical alternative approach. Yeah, exactly. So even though there's this regulatory push towards the secured overnight financing rate or SOFER, there are, well, there is the potential for. alternative rates to enter the market. And we have the perfect person to talk about this. We're going to be speaking with Richard Sandor. He's the chairman and CEO of the American Financial Exchange. Also, someone who occasionally is referred to as the father of financial futures,

has a lot of experience in the derivatives market and has, well, invented quite a few contracts over the years. So, again, the perfect person. I'm really looking forward to this. Okay. Let's bring him on. Richard, thank you so much for coming on all thoughts. Oh, it's my pleasure. Thank you for the invitation, and I'm happy to be here with both of you. Thank you. Oh, thank you.

So I gave a little bit of an intro just then, but it's kind of hard to summarize your career because it's quite expansive and you've done quite a few things. Can you try to summarize it in a nutshell for our viewers? viewers, for our listeners, I should say. It's really hard to talk about yourself. I leave that to others generally, but let's say I'm a serial inventor and a financial innovator.

I get it wrong a bunch of times and then get it right to. So I've spent 45 years trying to observe capital markets and see what instruments can be developed to minimize transaction costs and achieve social objectives. And LIBOR and its successors fit into that. And like most inventive activity, there's a spark. And we had sold our last exchange, which was a series of market-based solutions to global warming to ice in 2010. It was very successful. Our investors made seven and a half to 15 times their money between 0.3 and 10. A sale price was 600 million, and we had developed exchanges

in North America, the UK and China. And we reformed the incubator, which is something called the because we were looking for new markets. And we started to look at water. We had a contract with the state of New Mexico, California, looking at China, because we thought that water would be, and still do think, the commodity of the 21st century. I picked up a newspaper in 2011 and read that the Royal Bank of Scotland fired four, four people for manipulating LIBOR.

I called the team in, and even I know it takes two to manipulate. So if there was one, then there was going to be a second, and if we binomially expanded, two would go to four, four would go to eight, et cetera, and that ultimately we thought that there would be a demise in LIBOR, it would end, and that we would set off on a 10-year Odyssey to develop a replacement to LIBOR. LIBOR was unusual, and in that it was the only asset class that I knew about that had a single

benchmark, all because of a loan in the 60s to the shopping. Iran. If you take a look at crude oil, it's got WTI, it's got Brent, it's got Dubai, it's now got a Shanghai. If we look at the equity markets, they have NASDAQ, S&P, Dow, Russell, Vaguline, more stock indexes than there are stocks. And the same with fixed income. So what is this anomaly called LIBOR, and how could we have hundreds of trillions of dollars tied to a poll? That would be like electing the president of the United States based on the Wall Street Journal poll. It made no sense whatsoever that it was the only benchmark, and it wasn't even market determined. So we set out and said, let's develop something that is everything that LIBOR isn't.

Let's make it transparent. Let's make it regulated. Let's make it based on transactions only. And let's make it American. London has LIBOR, Europe as Europe, even Hong Kong has Heibor. could it be that the world's largest economy didn't have its own benchmark? So I got on a plane, and instead of going to London, Paris, Shanghai, Hong Kong, and Vienna, etc., I ended up in Bentonville, Arkansas, Tupelo, Mississippi, San Antonio, Texas, Green Bay, Wisconsin,

and visited 125 small banks with my colleagues. So if it was going to be a benchmark, it would be one that was based on American banks overnight, unsecured lending to each other. We were naturally viewed with some skepticism. Interest rates were zero. People said, LIBOR is never going to go away. You don't understand Dr. Sandor.

This is the bedrock of all finance. And you're climbing up a mountain, and you need to go back to Chicago because that's not the way it works. We felt quite opposite. And actually, as a contrarian and as an inventor, that was really bullish because everybody thought there was no need for it. And oftentimes, in my experience, whether it's financial futures, the derivatives, everybody said no need for it,

whether it was acid rain and the market, no need for it, catastrophe bonds, no need for it, climate change, no not happening, no need for it. So whatever small success I've had, it's been where the lights and beacon of the industry has told me that there's no need for it. I'm June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators. and the legal moves driving the markets. From corporate law to constitutional law

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On the East Coast, listen as you start your day. And on the West Coast, catch up in the evening. That's the Bloomberg Law podcast with me, June Grosso. Subscribe today wherever you get your podcast. So talk to us about your approach. So you mentioned this sort of absurdity that the world operated on a single benchmark, even though most things, whether it's stocks or multiple benchmarks, all around the world. what is it about the way that your index would be constructed that's, A, better for use, why regionalization is good, but also less prone to some of the manipulation issues that, of course, accelerated or caused LIBORs demand.

Great question. So we, again, we thought that we would stay away from SIFI, the system. important financial institutions. And we would go to recruit the 5,000 banks that were non-SIFIs and not go after the 15 CFI. So our market was going to be 5,000 banks that have approximately $9 trillion in assets, about half of that infloting rate. And that would be regionals mid-sized commuteries. Unity banks. And if we had breath as well as depth that competitive markets like wheat and soybeans and gold, et cetera, that were regulated and were transaction-based manipulation could not occur. And if it did occur, if it was regulated, we had policing and enforcement powers. So we hooked up with CBO. We said, Here's our algorithm.

Here's our benchmarks. You have a big compliance department. You're an SRO. You own a securities exchange. You own a commodities exchange. Why don't you be our compliance folks and take a look at every single transaction, have the complete tape, have a complete compliance thing, and we will make sure that we are not manipulable.

and we will have anti-spoofing rules. Concentrations will be limited. We will be able to speak to anybody. We have a business conduct committee. We have a 125-page rulebook of dues and don'ts. We have the ability to bring up a bank that misbehaves before a business conduct committee. We know how to do this. So we set in place all of the things that,

traditionally regulated and transparent markets perform. So we started with four banks. We traded 13 million a day. We're up to 143 banks, another 1,200 correspondence. So we have about 30% of America's banks. We trade $2.5 billion a day after four years. And we have 80 participants in any given quarter or months. So we are deep and we are broad. We also brought in IASCO because we thought it was important that we get independently audited with regard to liquidity, concentration, etc. So an independent audit was accused by a major accounting firm that said we were IOSCO compliant. When we hit a billion dollars a day, we went and got a CFTC approval. They have to make sure the index is viable before they allow you to trade the futures.

And we have broadened the market from not only 143 banks. They include all of the big regionals, regions, Northern Trust, fifth, third, etc. of 50% of the banks just under between 5 and 60 billion and 1,200 community banks. We also have Jeffreys, the broker-dealers, insurance companies like Northwestern, money managers. Guggenheim just had joined, and now we have companies like John Deere. We feel that a transparent, regulated market that has 80 participants, that does billions, day is an adequate benchmark. And you can see the tape. Every trade is transparent. It can be monitored. It can be audited. And so we feel we've just taken an age old tradition that exists in Chicago,

provide many buyers and sellers of a broad commodity financial instrument. and the rest will take care of itself. Richard, I wanted to go back to, I guess the notion that you had that you didn't have to have a reference rate, a sort of one-size-fits-all reference rate, you could have shades of it. I have maybe a stupid question, but some people would perhaps argue that one of the good things about having a benchmark, a single benchmark, is the simplicity. how would you respond to that idea? That's great. Simplicity is fine. If you're willing to roll the entire world economy on simpleness,

then you get what you would get a total breakdown. You get simplicity, but you just get a financial crisis. Why would you, look, well, I'm a professional economist. I teach at the University of Chicago. I've been doing it for, 45 years. Economists don't know anything, okay? We can't forecast. We haven't foreseen two major crises, meltdowns, things of this thing. There's only one thing you could probably get every economist. So if you go to China, you go to London, Oxford, you go to the University of Chicago,

one and only one thing will everybody agree on. And that is diversification. Right? That's, you probably will get nobody will argue against diversification. Right. Right? It's the one thing we know. We don't know whether the market's going to go up or down, whether it's going to crash, fall apart.

We don't know anything in finance and economics other than choice in diversification is good. So obviously, you know, as you say diversification of things are good. the dependence on a single LIBOR proved to be problematic. As we set up in the intro, regulators are pushing for this LIBOR replacement SOFER, which we've discussed based on overnight secured financing. You take a different approach. Can your vision, your index thrive in a world in which regulators

are pushing for everything out, are pushing for another sort of universal LIBOR replacement? And can we have this sort of diversification, even if regulators sort of have the specific vision? I don't think regulators are as singular in their attitudes and thought processes, as the popular press would indicate or the financial press. We have spoken to them, and that is, and we briefed, because this is how we operate. For the last five years, we go down in Washington, we brief the Fed, the OCC, the FDIC, the SEC, the CFTC.

And when I say to them what I am sharing with you, that there should be a free market for ideas, competition for ideas. Not one, not a singular one, said that's a bad idea. They have not said they are officially neutral. We already have our premise

from 2011 being validated. We got Sofer, we got Sonia, we got Toner, we got Esther. We're already breaking down the idea that a simple idea. Now, why would you have only a risk-free rate? You need a risk rate because, in fact, what we've learned in the last two crises, there's a flight to quality and interest rates between government

guaranteed paper and private borrowing, non-public, diverge crises and secularly when there's a recession. So you need a credit component in an index. We are the only index that has a credit component. 5,000 American banks want to develop assets, which reflect their borrowing costs so they can match the two in an asset liability management process. So if you want to make the banking system stable, you should develop floating rate assets that reflect the floating rate costs.

And for 5,000 American banks, the risk-free rate is fabulous. We believe in sulfur. We think it's a great thing. It's terrific for the money center banks. It doesn't fit. And the 5,000 small banks, getting back to my opening comment, about social purpose. We had Jeremy Stein,

who is the chair of the Harvard Economics Department. We funded a lecture at Northwestern two years ago, and it's unambiguous that these mid-sized regional and small banks disproportionately create

jobs in America. This is a critical time in our economy in the world. Why would one be against the instance institutions that function and provide financing to America's businesses, small businesses, which disproportionately create jobs. I don't get that opposition. It's like being in a McGrit painting. It's surreal. Richard, you're talking about the importance of having a credit

component in this benchmark reference rate. I wanted to ask you, I think the loans that you're looking at include not just loans between banks, but also between broker-dealers and private equity as well. I think that's right. Could you maybe talk a little bit about why you thought it was important to include those entities as well? Yeah, I think the job is not only to create liquidity in the banking system, but it is to bridge the market between the banking system and the capital markets. And if you have Cerberus or Jeffries or John Deere or Northwestern Mutual that also are sources of liquidity, then you bring to bear the power of more and more players and greater breadth to the market.

So that's why we, and all of those folks either have floating rate assets, they have asset liability management, they have capital market debt. So there's a natural nexus and why LIBOR was confined only to banks, again, is a historical accident. And if you wanted to design, it was like saying, okay, I'm going to design a car. And it's going to be a two-wheeler like a bicycle because everything before has two wheels. And therefore, I don't care if it's a car and needs four wheels. It's like a bicycle. So let's make it a two-wheeler. If you broke down almost anything you do and if you look at inventive activity,

you tailor it to what the more of it needs and wants. And again, we're struck by, well, that's the way, you know, my grandfather used. to do it, so I'm going to do it the same way. A lot of short daily news podcasts focus on just one story. But right now, you probably need more. On Up First from NPR, we bring you three of the world's top headlines every day in under 15 minutes. Because no one's story can capture all that's happening in this big, crazy world of ours on any given morning. Listen now to the Up First podcast from NPR.

Richard, here's what I'm trying to still wrap my head around, because what you're saying makes a lot of sense that it doesn't necessarily benefit the country as a whole to have a lending index that's heavily skewed towards built around the big banks, that smaller companies, real economy companies like deer, local banks, key for job creation. All that being said, how does it in practice, how does the use, how does the use, use of Ameribor, your index improve actual business functioning versus some of these other benchmarks when it comes to the actual writing of loans and other deals that need some index to be built up. Two ways. Remember that banks lend not based on a risk-free rate, right?

So if they are forced to create assets that are risk-free, then there will be volatility and their asset and liability. It will create uncertainty. It will reduce profitability, and therefore it will cause interest rates and profitability of banks to be lowered or account for the risk they. take and interest rates to be higher for borrowers to reflect the increase volatility associated with running the business. It's just like competition narrows the spread between wholesale and retail prices, and it's true for supermarkets, car dealers, and it's true for interest rates. the more you get and the more the commodity becomes homogeneous, the greater the benefits to the institutions through higher probability and to the consumers through lower costs.

It's no different than any other commodity. Richard, you spoke a little bit about adoption of Ameribor. I guess I'm curious, what's the next step for the reference rate? to Joe's point, what would it take for adoption to really sort of take off or what are you aiming for? Great question. You guys are super. You put a smile on my face. So in 2011 when we did this, why experience whether it was bond futures or asset rate or anything? It takes a decade to develop a market. So in 2011, we said this is going to take 10 to 15 years. Zero to two is toddler.

Two to five is kind of teenager and young adult. And five to 15 is adulthood. We're eight years into the process. We got lucky when we said 10 years that the, and there was no judgment. It was a stroke of luck that we called for a 10-year horizon, and just when LIBOR ended, 2021. So we now have, and this is true, whether it's the personal computer, you know,

or the iPhone, these things take a generation to go. So we are now getting banks that are starting to price the loans that they make based on Ameribor, 50 million, 20 million, 100 million. They show on their graphs that they have a high correlation to the old LIBOR, so it's very easy to educate customers. Equally, as we have adoption of floating rate, they're using a 30-day average because they can go on to Bloomberg,

they can go on to, you know, vendor Ameribor.net, see the price of this perfect transparency, and they're using a 30-day average. On June 8th, we will launch a monthly futures contract on the 30-day average AmeriBore to reflect what banks are pricing loans to auto dealers in Memphis and small milk farmers in Wisconsin, you know, $100 million manufacturing companies in Arkansas. That's how the loans are going to get priced. And then once that happens, we will, and we are educating swap dealers now who already deal with these banks to swap floating to fixed. and the swap dealers will be matched with a bank who's issued a floating rate loan to a corporate.

They will develop a swap. The swap will be hedged in the futures, and that is the final link in the maturity of the market. So as we see banks adopt a Meribor as a benchmark, give it to corporates and small businesses on loans, then the banks go to either a money center bank or a large bank to do a swap, and then that feeds the future, and then it's just a matter of replication. And we figure that's probably two to five years. We will see the ultimate broader adoption of Ameribor as a benchmark. And again, we see a world in which Sonia, Sulfur, Maribor, you know, there'll be a rate in Europe.

We've already educated some central bankers there. And there'll be a rate in China that the whole benchmark will be disrupted and we'll see a whole family of different rates. Richard, well, we'll have to have you back on in a few years to talk about what's going on with the Maribor in the U.S. and also potentially some reference rates outside of the U.S. as well. Thank you so much for coming on all thoughts. This is my pleasure. Thank you. Your questions were intelligent, well thought out. Thank you very much. Thank you.

Thanks, Richard. That was great. His point about how there's no reason why you have to have a single benchmark and it's kind of weird that for something as important as this sort of lending or interbank benchmark that you only have a single one, I think that's really interesting. I did too. I also think it's interesting this idea of wanting a credit component in the benchmark itself. Because, of course, with SOFER, it's like the idea is there really shouldn't be much of a credit component.

It's secured and so on. But then, of course, if you're going to build a loan on top of SOFER, then you have to, like, calculate a credit spread or some sort of market, the market will determine a spread on top of that. So it'll be interesting to see if it makes more sense, and to his point, sort of a local, regional company capital efficiency, if it makes more sense to have a benchmark that includes the sort of the credit conditions of the American economy overall. Yeah, and that risk-free rate idea that's embedded in SOFER, I mean, that's very different to the original concept of LIBOR. And so from that perspective, you can see something like Ameribor that does include that credit risk component.

You could see that trading much more closely to LIBOR than SOFER, I think. Yeah, yeah, exactly right. And, of course, even if you look at on our terminal right now, you see there's a pretty big, you know, noticeable spread. between Ameribor and so far as it is right now. So it'll be interesting. Again, it sort of goes back to this idea of all of these things, whether we're talking about a reference rate, whether we're talking about a currency as sort of de facto social networks, or at least having big network effects.

So obviously Libor had the ultimate network effect, but then it sort of faded. but it'll be interesting to see if Ameriore can get enough traction so that people feel value in continuing to use it. She's a good reason to have Richard back any, I don't know, six months or a year or something like that. Yeah, for sure. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allo. And I'm Joe Wisenthal. You can follow me on Twitter at the stalwart.

You should follow our producer on Twitter, Laura Carlson. She's at Laura M. Carlson. Follow the Bloomberg head of podcast, Francesca Levy, at Francesca Today, as well as all of the Bloomberg podcast that can be found under the handle at podcasts. Thanks for listening.