To my gentler readers, first an apology for this interregnum in publication. I’ve been sitting on this commentary like a hen on an egg for weeks. All I can say is having to work for a living gets in the way of writing about interesting stuff.

It’s now July and supposedly the transition from LIBOR to SOFR is almost already a done deal. Anyone notice that happening? Not to bury the lead but it hasn’t happened. Note that even the ARRC, between harrumphs about the slow take-up of SOFR products, has said that MAYBE they’ll let folks use Term SOFR soon (although they are still being a bit cagey on when and, perhaps more importantly, who will be given that privilege). That’s not good if we’re gonna base an entire floating rate marketplace on SOFR.

It’s now been a few weeks since the SEC’s newly minted chair, Mr. Gensler’s broadside against Bloomberg’s BSBY and the Fed’s publication of its most recent fulminations about these LIBOR-like alternate indexes. Also weighing in was Andrew Bailey, the Chair of the Bank of England, and the Godfather of SOFR-nomics, who, with furrowed brow, expressed concern over the distraction being caused by these alternate index rate runners.

All of these critics of BSBY and the other credit-sensitive alternative rates complain that these index wannabes have the same fundamental vulnerability of LIBOR; that the trading volume of transactions under these indexes is not as broad as the transactional base of SOFR (which as noted above by the estimable Mr. Bailey also has some vulnerabilities).

Okay, but is a modest underlying data set a fatal flaw for these credit sensitive indices? Is that the end of the story?

This regulatory piling on in the here and now seems a bit of an unseemly bum’s rush. It feels a lot like the residents of the heights of our regulatory establishment are rallying around one of their own when questions begin to arise; the tribe closing ranks and damn the merits of any arguments to the contrary. Okay, the right honorables may tut-tut to each other along the halls of power that the ARRC’s obdurate refusal to pay any real attention to what markets are saying about SOFR might be troubling but hey, you gotta break some eggs to make an omelet. Those quibbles and cavils must, for the good of the ARRC (whoops, I mean the country, don’t I?), be ignored! The ARRC has said that the question has been called and markets need to move on and learn to live with SOFR.

But markets are funny things. The Ragin Cajun James Carville famously said “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” Markets don’t like to be bossed around.

If you want to know what the market thinks of SOFR, just look at its take-up to date, notwithstanding all of this regulatory sturm und drang. It’s not going well. The fact that markets prefer LIBOR to adjusted SOFR is all you need to know to understand SOFR is not really a great idea.

We’ve written about this in the past and continue to urge the government types to give markets some more time to solve the problem themselves.

Let’s step back a moment and acknowledge that trillions of financial assets priced off a modest set of actual underling transactions is not ideal, but exactly how troublesome is it? We indeed know that a few years back a number of rogue bankers diddled the quotes for LIBOR for their own pecuniary advantage and that’s certainly not good. At least in those specific instances, there was an artificial and inappropriate transfer of value between deal parties. Someone paid more for credit than they should have. But let’s step back just for a moment and ask how badly markets were actually damaged because of this nefarious behavior. The answer, of course, is that if the LIBOR market worked pretty well for 40 years before the bad guys were caught and shockingly, it still working pretty well today, notwithstanding all the noise. The market thought and thinks that LIBOR reflects borrowing costs between and across high-quality financial institutions and therefore representing a baseline of counterparty risk on which it is not unreasonable to construct the edifice of both a cash and a derivatives marketplace. Tell me again exactly how LIBOR failed to work and what actual damage to the marketplace resulted from the bad behavior of a small number of nefarious bankers in a handful of instances? Tell me why we need to rip it all up and fix it because of this? Okay, I give up on all of that. The train has left the station on LIBOR, but the exact construction of a new index is not indeed settled.

The BSBY and the other credit-sensitive indexes that are being developed in the open market of ideas by private market participants are indeed based on a broader range of actual transactions than the current staggering towards zombie land LIBOR. While the data set are not as voluminous as SOFR, they are real and not insubstantial. None are backed by opinion; none are based on windage; the underlying data points are all from actual trades. What’s the real risk that the underlying volume of transaction is thin? I really don’t see much as we seem to have lived successfully with LIBOR for decades while trading volumes got thinner and thinner. If the index is used and counterparties trade on it and it’s generally recognized to represent market trades with a baseline risk component is that really so bad?

And look at the other side of the coin here; SOFR contains no credit risk component. It’s generally recognized that in periods of credit disruption, SOFR will likely retreat while LIBOR or any other index with a credit component will likely go up. For markets as a whole, which do we prefer? Of course, the price of credit should go up when credit is disrupted.

Take note also of the special frisson to be experienced by everyone who has put money to work on a SOFR index while watching the “non-representative” but still published LIBOR go up and up while SOFR retreats. If LIBOR starts to spike and SOFR stays quiescent or goes down, how good will everyone going to feel about that? Self-schadenfreude? Talk about rubbing our face in it.

Across the likely range of outcomes for the performance of the economy over the short to middle term, credit risk is likely to go up and credit will get dear. Some combination of inflation (how good do you feel about all those assurances of transitory inflation?), post-pandemic radically expansive fiscal policy, and in almost breathtaking expansion of the Fed’s balance sheet can only be held at bay so long and credit-sensitive borrowing rates ought and surely will go up… but they won’t in SOFR-land. Well, what’s the consequences of that? First, it’s a transfer of value from the providers of money to the users of money, from the providers of liquidity to the users of liquidity. That certainly wasn’t what was intended. In the absence of a credit component in the index, how does one price that variability? Surely the price of credit will widen. If not in the first instance, shortly after lenders begin to experience an adverse transfer of value. It all seems like it actually might have a depressing impact on capital formation.

So, in addition to unintended value transfers, the broad use of SOFR is likely to have a constricting impact on credit availability. What you can’t price is difficult to sell and difficult to buy. So having slayed the risk that the judgment of some individual bankers twerked by self-interest caused a few bad prints, and one must suspect relatively modest transfers of value from the providers of capital to the buyers of capital in only a few instances, we are creating an actual problem for capital formation that may well dwarf the economic dislocation from a mis-set LIBOR. The index on which trillions of dollars of transactions we based will no longer be responsive to credit conditions. I don’t care what you say, that’s bad.

Maybe ARRC is the answer. Maybe it’s the best house on an ugly street. The best answer amongst a bunch of flawed alternatives. It’s not great that the government’s putting its finger on the scales in a process where free markets are endeavoring to come up with a right answer of how to price floating rate debt. The jury is still out. Give the market time. If ARRC is such a great idea, the market will embrace it in the next year or so, but the state’s five-year planning sort of effort to tell the markets what to do is a bad idea and probably won’t work. It is the .400-hitter on the team.