A key advantage of Ameribor is that it better represents actual funding costs for many small and mid-size American banks, as compared to SOFR.
Background
With the phaseout of the London Interbank Offered Rate (LIBOR) just over a year away, market participants are urged to focus on preparing their loan agreements for a successful transition to a replacement reference rate. To facilitate this transition, the Alternative Reference Rates Committee (ARRC), convened by the Federal Reserve Board and the Federal Reserve Bank of New York, has identified the Secured Overnight Financing Rate (SOFR) as its preferred alternative reference rate for USD LIBOR. There are several potential SOFR replacement rates and choices to be considered, including whether to choose between SOFR calculations using simple or compound interest and whether to choose a calculation in arrears or in advance. However, many Main Street banks have voiced their support for an alternative LIBOR replacement rate―the American Interbank Offered Rate (Ameribor).
What Is Ameribor?
Ameribor is a benchmark interest rate calculated as a weighted average of the daily transactions in the Ameribor overnight unsecured loan market on the American Financial Exchange, LLC (AFX), which is a self-regulated exchange operating since 2015. Ameribor is an interest rate expressed on an actual/360 day count and following business day convention basis that is rounded to the fifth decimal place. Like SOFR, this benchmark interest rate is an International Organization of Securities Commissions (IOSCO)-compliant benchmark, based on a volume weighted average of daily unsecured interbank transactions by AFX member institutions. As of June 25, 2020, the volume of the transactions on AFX since 2015 had reached $1 trillion.
In a March 2, 2020, interview, Richard L. Sandor, chairman and CEO of AFX and founder of Ameribor, referred to Ameribor as “the most boring benchmark in America” because, according to Sandor, Ameribor is “the least volatile of interest rate benchmarks.”
The Case for Ameribor
There are several advantages of using Ameribor as a replacement reference rate for LIBOR, as discussed on AFX’s website. A key advantage of Ameribor is that it better represents actual funding costs for many small and mid-size American banks, as compared to SOFR. More specifically, Ameribor is calculated based on unsecured transactions, whereas SOFR measures the cost of borrowing cash overnight collateralized by U.S. Treasury Department securities. For banks that do not have large holdings of government securities and therefore can only borrow on an unsecured basis, Ameribor would be more representative of their actual cost of capital and risk profile than SOFR. For example, during a financial crisis, the cost of borrowing on an unsecured basis would rise more than the cost of borrowing on a secured basis. Thus, in case of financial stress and rising credit risks, market participants using SOFR in their unsecured loans would have the loans underpriced while their funding costs skyrocket. This is the reason why many small and mid-size banks supported Ameribor as a replacement rate for LIBOR. In fact, some mid-size financial institutions have already started to price their loans using Ameribor.
In addition, SOFR presents risks that smaller financial institutions may not be able to hedge as easily as larger banks. SOFR is generated from thousands of overnight repo transactions, a market that is impacted by global events including credit issues of foreign banks outside of the United States. Ameribor, in contrast, results from funding transactions among American institutions.
The Fed’s Take on Ameribor
On February 26, 2020, 10 mid-size banks wrote a letter to the Federal Reserve Board, cautioning against using SOFR as a single benchmark replacement rate and asking that Ameribor be considered. On May 28, 2020, Federal Reserve Board Chairman Jerome Powell provided a written statement in response to a “question for the record” from Republican Senator Tom Cotton of Arkansas following Chairman Powell’s testimony to the U.S. Senate Committee on Banking, Housing and Urban Affairs held on February 12, 2020. Senator Cotton asked if the Fed supports alternative benchmark interest rates besides SOFR, such as Ameribor, for the replacement of LIBOR.
In his statement, Chairman Powell stated that it is the Fed’s view that SOFR is a robust alternative that will help many market participants transition away from LIBOR. However, Chairman Powell indicated an openness to additional alternative rates, stating that “we have been clear that the ARRC’s recommendations and the use of SOFR are voluntary and that market participants should seek to transition away from LIBOR in the manner that is most appropriate given their specific circumstances.” While admitting that “[Ameribor] is a fully appropriate rate for the banks that fund themselves through [AFX] or for other similar institutions for whom Ameribor may reflect their cost of funding,” such as small and mid-size regional and community banks, Chairman Powell also pointed out that Ameribor “may not be a natural fit for many market participants.”
AFX Chairman Richard L. Sandor responded that Chairman Powell’s comments “reinforce the importance of choice.” According to Mr. Sandor, SOFR and Ameribor “are complementary to each other,” not competitors, and offer robust alternatives to LIBOR.
Having chosen SOFR as its preferred alternative reference rate for USD LIBOR, the ARRC has made various tools available to help market participants to transition to SOFR, including SOFR best practices, a user’s guide to SOFR and recommended fallback language that help market participants write contracts referencing SOFR.
For now, the lack of similar resources for Ameribor may impose higher transactional cost of transitioning from LIBOR to Ameribor. It will also be interesting to see if an Ameribor derivatives market takes off.
But SOFR Is Not the Only Alternative
Despite the dominance of SOFR, Ameribor is gaining greater traction, and market participants are encouraged to take note. Since it is not possible to provide one-size-fits-all advice on what a benchmark replacement rate should be, parties in USD LIBOR-linked contracts should consider the options of replacement rates and consult with counsel as appropriate.
About Duane Morris
As the end of LIBOR draws closer, Duane Morris’ LIBOR Transition Team will continue to monitor developments and issue additional Alerts.
For More Information
If you have any questions about this Alert, please contact Joel N. Ephross, Roger S. Chari, Amelia (Amy) H. Huskins, Phuong (Michelle) Ngo, Han Wang, any of the attorneys in our Banking and Finance Group or the attorney in the firm with whom you are regularly in contact.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.