Weaning off the scandal-plagued LIBOR benchmark is a giganticproblem for global rates markets, one that increasingly looks tooburdensome for a single replacement to handle in the UnitedStates.

Global regulators decided to move away from the London interbankoffered rate—a vital part of the financial system given that it'slinked to, at last count, about $350 trillion of loans,derivatives, and other instruments across various currencies—afterprosecutors found that banks around the world manipulated it. Italso didn't help that volumes underlying the benchmark dried up.For the U.S., a group backed by the Federal Reserve pickedsomething called the Secured Overnight Financing Rate, or SOFR. It launched a year ago Wednesday.

But the Bank for International Settlements, which serves as thebank for central banks, said in March that a one-size-fits-allalternative may be neither feasible nor desirable. Although SOFRsolves the rigging problem, it doesn't help participants gauge howstressed global funding markets are. That means SOFR is likely tocoexist with something else.

“The market likes the idea of having something that has creditrisk embedded in it, so if the market wants it, I'm not sure theFed is going to be able to stop it,” says Mark Cabana, head of U.S.interest rates strategy at Bank of America Corp.

How this actually will play out in the U.S. is uncertain.Revamping LIBOR itself makes sense given that it remains theguidepost for fixed-income markets. Intercontinental ExchangeInc.'s ICE Benchmark Administration division, which oversees LIBOR,has outlined another possible successor called the Bank Yield Index. Another option is AMERIBOR,the brainchild of Richard Sandor, who in the 1970s helped inventthe interest-rate futures market while serving as the Chicago Boardof Trade's chief economist.

Here are the leading contenders, and their pros and cons:

SOFR: The Heir Presumptive

SOFR, which debuted in April 2018, is set daily based onovernight repurchase agreement transactions secured by U.S.Treasuries. It was the preferred benchmark of the Fed's AlternativeReference Rates Committee, a collection of regulators andrepresentatives from the private sector. Futures and otherderivatives linked to it are already trading. Right now, it's justtied to overnight funding, but officials intend to introducelonger-term rates.

Pros:

• There's already a lot of trading in the repo markets thatunderpin it, with volume on related securities averaging about $843billion a day since the benchmark's launch a year ago, according todata compiled by the Fed Bank of New York. That's vastly more thanthe median daily volume of funding transactions that supportthree-month LIBOR, which is less than $1 billion.
• The SOFR futures market is growing. Total open interest in CMEGroup Inc.'s one- and three-month SOFR futures contracts wasroughly 149,000 as of March 19, up from about 51,000 at thebeginning of 2019.
• The Federal Home Loan Banks (FHLBs), the largest issuer ofshort-term LIBOR-linked debt, are issuing floating-rate securitiestied to SOFR. FHLBs have issued about $32 billion of the securitiessince November.

Cons:

• It got quirky around the end of 2018, surging from 2.46 percenton Dec. 28 to 3.15 percent on Jan. 2, then back down to 2.45percent two days later. Since then, the rate has jumped by about 20basis points at the end of each month. Many downplayed thesignificance of this jumpiness, explaining that SOFR-linked reposgot tumultuous as banks tidied up their balance sheets at the endof the year, when regulatory surcharges are calculated. But it doesshow funding conditions could rile the rate in the future.
• While total open interest on SOFR futures continues to rise,the number of swaps transactions is erratic. Swaps transactionsamounted to about $13.1 billion of notional value in March, a newmonthly record, according to data compiled by Depository Trust& Clearing Corp. Yet $10 billion of that was simply hedgingagainst the possibility that repo rates would spike at the end ofthe quarter.
• Market participants are still awaiting the creation of a termstructure, or maturities beyond overnight. LIBOR and other ratesalready have these, but minutes from the Federal Open MarketCommittee's January meeting show the central bank is still workingon this area for SOFR. Fed staff issued a paper in February aboutinferring term rates from SOFR futures prices.

LIBOR: The Devil You Know

Through a daily survey, about 20 large banks estimate how muchit costs to borrow from each other without putting up collateral.Since taking over LIBOR from the British Bankers' Association in2014, ICE Benchmark Administration has tweaked the rate'scalculation to incorporate commercial-paper transactions whenpossible. These are real trades, not just estimates, and act as aguard against manipulation.

Pros:

• The market is still huge. Despite the push from regulators toshift outstanding contracts to a new reference rate, more than $350trillion of securities are still tied to LIBOR across currencies,with $200 trillion of that denominated in dollars.
• Because it's based on wholesale bank transactions, LIBORcurrently acts as a key benchmark of credit risk in the globalfinancial system.
• LIBOR gives a longer-term peek into funding conditions becauseit's published across seven maturities, ranging from overnight toone year.

Cons:

• Volumes for transactions that underpin LIBOR have been anemiclately compared with those tied to SOFR and the upstart AMERIBORrate.
• Regulators believe there's still a stigma surrounding LIBORbecause of the rigging scandal.
• Now that the benchmark is calculated from actual trades—throughthe use of what's called a waterfall methodology—it may be moresensitive to changes in bank funding conditions. For example, thethree-month tenor plunged by 4 basis points on Feb. 7, the largestone-day slide since May 2009.

U.S. Dollar ICE Bank Yield Index: Not Quite There

The Bank Yield Index (BYI) was introduced by LIBOR's overseer,ICE Benchmark Administration, or IBA, in January. The new gauge isdesigned to measure the yields at which investors are willing tolend U.S. dollars to large, internationally active banks on awholesale, unsecured basis to meet the needs of lenders, borrowers,and other cash-market participants.

Pros:

• The Bank Yield Index is based entirely on real trades,including banks' commercial paper and certificate of deposittransactions.
• No single issuer is allowed to represent more than 10 percentof the transactions used to determine the rate, an attempt toprevent a single firm from skewing the result.
• It looks at more than overnight rates, with IBA producing it ona preliminary basis for one-, three-, and six-month tenors.

Cons:

• It's not ready yet. IBA collected feedback from marketparticipants through March 31. IBA hopes to begin publishing therate in the first quarter of 2020.
• Despite being transaction-based, the bigger issue is thatunsecured bank funding remains thin after regulations stemming fromthe 2008 financial crisis. This is a problem it has in common withLIBOR.
• IBA has said there's no guarantee it will continue to test BYI,be able to source the data, or publish the index in the future. Itadvised LIBOR users not to rely on its potential publication whendevising LIBOR transition or fallback plans.

AMERIBOR: The Dark Horse

This nascent daily benchmark reflects the borrowing costs fortransactions between members of the American FinancialExchange—small and midsize U.S. financial institutions, mostlybanks.

Pros:

• Unlike SOFR, AMERIBOR has been steady at month- and year-endperiods.
• Since launching in December 2015, both volumes and the numberof users have grown. The exchange had roughly 700 banks on itsplatform as of the end of March, with average daily outstandingvolume amounting to $1.45 billion. That's up from 11 institutionsand $13 million in volume when it started out.
• In addition, commercial banks have started issuing loans tiedto AMERIBOR. On March 5, Brookline Bank in Boston become the secondbank to issue a commercial loan indexed to the reference rate, withmore in the pipeline, American Financial Exchange Chairman and CEOSandor said. He also said that AMERIBOR futures are planned for thesecond or third quarters.

Cons:

• Its global breadth is unknown. AMERIBOR targets financingconditions for smaller U.S. banks, whereas LIBOR and BYI are moregeared toward dollar-denominated global funding conditions formultinational financial institutions.
• The term structure is in its infancy. The American FinancialExchange intends to move further out the curve with the creation ofa 90-day rate, although it has only recently introduced a 30-daytenor.

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