Regulators' SOFR Power Grab. Debt Markets At A Crossroad

Summary

• Close-to-zero interest costs are at an end.
• Higher and more volatile interest rates are inevitable in the coming healthy market economy.
• Our debt markets’ success in financing continued growth requires a market-priced liquid generic debt instrument.
• Longer-term growth will be problematic unless debt that attracts retail investors is allowed to flourish without federal intervention.
• This article describes a way forward.

BrianAJackson/iStock via Getty Images

Introduction

The financial climate is changing for the first time since the Financial Crisis of 2007-2008 – returning to a normal higher and more volatile interest rate environment. Either the markets for private debt will bring us smoothly out of this post-COVID recovery, easing management of the higher inflation and interest rate volatility that characterize a normal economy, or these markets will fall apart, leaving retail bond investors at the mercy of the sudden changes in investment costs that uncertain interest rates bring.

The health of the debt market is the key to future American economic growth. Private debt is arguably the most important component of the all-in cost of capital investment. Its importance measured by the ratio of debt to equity is displayed in the graph below.

Source: FRED

The most important positive measure that markets can pursue to ensure a healthy growing economy is to create a deep liquid generic debt market akin to the markets for passive equity exchange-traded funds. This article considers factors that work against the health of the market for debt and those that work in the market’s favor.

Factors working against healthy debt markets

Dodd-Frank restrictions on bank balance sheets. Regulators’ Dodd-Frank Act-inspired preoccupation with the safety and soundness of banks has led to bank withdrawal from market-making in debt markets. The banks have been regulated out of the business of maintaining debt portfolios large enough to provide broad market-making support for private debt.

SOFR. The current discussion of the state of the debt market focuses on the death of LIBOR, a once-important measure of the anticipated cost of credit. Financial market regulators have decided to put an end to LIBOR, replacing it with their invention, the secured overnight financing rate (SOFR). SOFR is dominated by the Fed’s policy intentions and provides little information about the cost of credit other than the current monetary policy stance. SOFR is a poor replacement for LIBOR.

If regulators force SOFR, a version of the overnight repurchase agreement rate, upon debt markets, keeping interest rates artificially low, our economy will overinflate throughout the coming decade. Thereafter we will repeat the disastrous 1970’s and ‘80’s stagflation.

The coming more normal volatile uncertain interest rate conditions are exactly the conditions that make SOFR a poor replacement for LIBOR. SOFR will be tightly controlled by the Fed using various facilities such as the New York Fed’s Standing Repo Facility, designed expressly to prevent SOFR and other overnight interest rates based on repurchase agreements from reflecting market forces.

When any fit-for-use market summary credit instrument begins to serve its purpose as a simultaneous bellwether and resource allocator, signaling the market opinion that credit risk and future interest rates are increasing, the Fed will have the brakes firmly applied to SOFR, producing what may be the right monetary policy but the wrong price of credit.

No debt market bellwether. Only a neutral exchange can supply an honest market bellwether, offsetting the negative effects of SOFR. To support a healthy capital market, investors need a summary debt investment that characterizes professional investor expectations for the overall performance of private capital.

A focus on the symptoms, not on the disease

To characterize this market crossroads as a choice of interest rate index numbers is to trivialize the deeper problem. The graph above displays the dependence of current American finance on debt, a result of a decade of near-zero cost of credit. The Fed’s bid to keep that cost near zero by forcing Fed-controlled artificially low SOFR upon the debt marketplace has about the same chance to succeed in financing normal economic growth that the little Dutch boy had to save his country by putting his finger in the dike.

The essential role that financial futures technology played in the health of debt markets during the past 50 years

Financial regulators fear financial futures markets. Futures technology opens markets to retail investors and creates a community of interest between retail traders and Wall Street – a bond that, once forged, can fend off an aggressive attempt by financial market regulators to seize control of market pricing.

The result can be a marketplace that retail investors can trust to give them honest judgment about the prospective return to the average dollar invested in the corporate marketplace. Regulators may prefer investors perceive credit to cost less than this, but the long-run interest of the economy is best served by the naked truth.

Regulators can use suasion on Wall Street to adopt SOFR, but the threat of hostile bank examinations that intimidate institutions has no chastening effect on retail investors. Since regulatory pressure to adopt SOFR carries no weight with retail investors, markets like futures with a strong retail investor presence are less likely to feel regulatory pressure to adopt SOFR.

Financial futures trading technology was one key catalyst for the recovery of our debt markets from stagflation in the 1980s. Eurodollar futures traded independently of Fed policy direction acting as a brake upon economic growth when it was needed.

But the London deposit market, the cash market upon which Eurodollar futures was based, was never going to be a springboard for commercial paper issuance. Nonetheless, we can create a source of corporate debt finance, with a futures-like springboard.

A new technology that combines spot and futures trading

The demise of LIBOR is a story with a lesson. Simply listing a futures contract with a private debt index number to settle upon at delivery is a non-starter. Regulators are reasonable to point out that financial futures settling at an index of the cost of debt, as they do today, can be taken hostage by individual issuers. The key shortcoming of financial futures – no control of the spot market that determines futures market prices – is the weakness that visited the ugliness of LIBOR upon Eurodollar futures and put CME at risk.

The technology of futures is a key to successful debt trading, but simply listing another debt futures settling at an index value will only return us to another LIBOR problem.

Any generic debt market that leads capital financing forward into the coming more volatile territory must control its spot market issuance.

And this spot market issuance must be more transparent than LIBOR was. With exchange sourced issuance the spot market for a debt instrument cannot be taken hostage by individual corporate issuers or government regulators.

LIBOR was never an ideal bridge between retail investors and issuers of private debt. It had certain attractive features. Namely, it applied financial expertise to measure a useful number – the anticipated cost of wholesale bank-provided credit at the three-month maturity. However, its many failings grew in importance throughout its 50 or so years of tenure as the world’s go-to source of a credit risky index, ultimately leading to its impending demise.

The strength of financial futures technology. The clearinghouse

The key characteristic that makes financial futures an equalizer of retail and Wall Street institutions and protects the market from the regulatory suasion of Wall Street that led to SOFR’s current dominant position is the use of a single clearinghouse that guarantees seller to a buyer and the reverse.

The clearinghouse protects both sides of the market – Wall Street and retail investors – from the weaknesses of the other. The clearinghouse protects Wall Street from the credit risk of retail investors. And the clearinghouse protects retail investors from being pressured by regulators who threaten Wall Street with the possibility of negative bank examination reports.

It is not an exaggeration to say that the regulator’s push to replace LIBOR – a rate dominated by retail traders and commercial banks – with SOFR is the regulators’ bid to seize control of the cost of bank credit.

Ultimately, the implication of Fed control of the cost of bank debt is that the too big to fail banks will join Fannie Mae and Freddie Mac – the two federal housing finance agencies with ambiguous federal credit protection that forces them to do Congress’ bidding regularly, including complete adoption of SOFR replacement of LIBOR-based debt indexing.

What is at stake?

Futures market domination. CME Group has three financial futures markets that are fundamental to its dominance of futures trading – Eurodollars, Treasuries, and Equities in that order. Equities futures have arguably been undercut by more equities-friendly trading technologies – options based on payments for order flow for single issues and ETFs for passive indexes. Thus, the interest rate contracts are the key to the success of CME going forward.

Put otherwise, if CME’s crown is to be seized by a competitor, the time is now, when private debt market futures and spot markets are up for grabs.

Private debt market liquidity. A far more important issue is liquidity in the market for private debt more broadly. Here LIBOR was useful in the pricing of the reset rates of most long-term and bank debt. SOFR, an overnight rate that also is inevitably directly tied to the Fed’s current monetary policy intentions, will be a poor replacement for LIBOR in this function.

What are the capabilities needed to seize the moment, developing a market for spot debt trading?

To take advantage of this moment a market that replaces Eurodollar futures needs the following features.

• Transaction technology like financial futures – open to retail traders and, ultimately attracting the participation of Wall Street as LIBOR once did.
• Investor-friendly Instruments – spot instruments that modify the terms of existing private debt breaking away from the usual issuer-created problems of debt.
• Exchange control of the issued instrument – complete transparency and clarity of the relationship between assets supporting the value of the issued instruments and the value of the exchange-traded instrument at the close of trading.

Transaction technology. Much of the technology of futures trading is passe. For example, the seasonal quarterly settlement cycle makes perfect sense when applied to agricultural commodities, but not when applied to debt, which needs a daily spot settlement yield.

The primary futures technology that permits retail participation is the clearinghouse that acts as a buyer to every seller and the reverse. But also important is the exchange monopoly on the traded instrument that prevents the trading of an OTC version of the futures contract – illegal if the contract is CFTC-approved. In other words, insiders cannot trade an inside version of the exchange-issued instrument legally.

Investor-friendly instruments. Existing private debt is not user-friendly. The key shortcoming of private debt for use in pricing of the cost of credit is the tendency of the prices of individual debt issues to be affected by parochial concerns affecting specific issuers.

It is too easy for issuers of corporate debt to modify terms of their debt to the detriment of holders – the kiss of death for market liquidity. Thus, the exchange or a related entity must collect original debt issues and modify their terms through pass-through-like securities that put market users in control.

Recent experience in the credit default swap market, described for example here, shows that there are fundamental conflicts of interest between market users and debt issuers that any liquid instrument must design the instrument to prevent.

Exchange control of the issued instrument. This is an important advantage that an exchange-issued instrument would have over any alternative. It would be a good thing if the instrument were not in portfolios of either public market participants like the Fed or private market participants like the too big to fail banks before settlement. That way, neither squeezes nor surpluses of the amount of the instrument the market seeks to acquire would be a problem.

Conclusion

The real moment of truth in the history of LIBOR and in dollar interest rate debt trading more generally is still a year or two away. When CME Group begins to settle expiring Eurodollar futures contracts with some version of SOFR, we will know that the market regulators have successfully gained control of the cost of American bank credit for the time being. This moment is still in the uncertain distance. I believe another generic debt market that provides a summary measure of the cost of short-term private debt will be established well before then.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.