In the US, a venture-owned fintech company is building a marketplace where something quite revolutionary is happening.
Whisper it, but it seems that banks that find themselves with an excess of deposits might lend them out overnight to other well-capitalized banks that find themselves temporarily short of funds.
For such short-term loans, banks do not even require collateral.
One might call this an interbank funding market. A robust one might be useful, given this year’s tremors when a few regional banks saw sudden, rapid and wholesale flight of customer deposits.
Even further out at the extreme edge of financial innovation, it is possible that the banks borrowing money in this interbank market to fund loans to businesses might price those loans at a margin above their own cost of interbank funding.
Richard Sandor, the economist and entrepreneur who pioneered interest-rate futures contracts on US Treasuries at the Chicago Board of Trade in the 1970s and later spot and futures markets on sulphur dioxide-emission allowances in the 1990s, founded and launched the American Financial Exchange (AFX) back in 2015.
The idea was to promote two linked products. First, an electronic matching engine – a self-regulated exchange but hosted on, and with market surveillance and compliance conducted by, Cboe Global Markets – that allows banks, credit unions and other financial institutions to lend and borrow overnight on an unsecured basis.
Member banks have insight into live bid-offer spreads and depth of market while setting out the qualifying criteria of banks that they might be willing to take the credit risk of.
Banks anonymously enter offers to lend surplus funds or bids to borrow them. When a match is found, their names are given up and transactions are settled directly between the banks with funds exchanged via Fedwire.
There are about 4,600 banks in the US, of which around one third have assets above $1 billion and are the target market for AFX.
“This is a robust interbank lending market,” John Shay, chief executive of AFX tells Euromoney. “We have 300 active users, including many regional and community banks that are core lenders to the real economy and would like to earn more on their surplus funds than they can be depositing them at the Fed.”
AFX says that it does about $2 billion of business each day, but there is clear potential to do much more. Lending banks have approximately $67 billion available to borrowing banks through 1,800 separate credit lines.
We calculate that AFX Marketplace accounts for around 50% to 60% of our members’ funding, or around 1.5% of the total unsecured Fed funds market
John Shay, AFX Marketplace
On November 2, the Fed’s overnight bank funding rate (OBFR) stood at 5.32%, while overnight Ameribor, the level at which regional and community banks with over $1 billion in assets actually fund one another on the AFX Marketplace, was 5.51%.
That implies an extra 19 basis points for lenders taking unsecured overnight bank risk. On $2 billion a day, that is $3.8 million.
What is the attraction for borrowing banks?
Community and regional banks in the US can obtain a subsidized rate of funding from the Federal Home Loan Banks (FHLBs), of which most are members and that pass on a low cost of wholesale funding in line with their own implied sovereign support as government sponsored entities (GSEs).
But the FHLBs lend against collateral after a haircut.
“While the Federal Home Loan Banks are a much bigger source of collateralized funding, we calculate that AFX Marketplace accounts for around 50% to 60% of our members’ funding, or around 1.5% of the total unsecured Fed funds market at the moment,” says Shay.
There are reasons why borrowers might absorb the slightly higher cost.
“Our removers that borrow in the market may not want to post collateral to the Federal Home Loan Banks or may not have close relationships with FHLBs,” Shay says. “But, even if they have to pay slightly more for unsecured overnight borrowing on AFX Marketplace, they can take that Ameribor borrowing rate and then use it as the basis for pricing loans to their own end borrowers.”
AFX estimates that anywhere from $8 billion to $10 billion of loans have been benchmarked to Ameribor.
Credit sensitive
Ameribor, AFX’s second product, is the volume-weighted average interest rate of the daily transactions in the overnight unsecured loan market on AFX Marketplace. It is the basis for calculating rates out to one- and three-month Ameribor.
It is the potential for Ameribor to become a Libor-replacement, credit-sensitive rate that it can license for derivative and other products that attracted 7Ridge, a private markets asset manager led by Carsten Kengeter, former chief executive of Deutsche Börse, to buy AFX back in April 2023.
“There is an ever-increasing demand for credit-sensitive rates, especially in the current macroeconomic environment,” Kengeter, a FICC specialist who once headed investment banking at UBS, stated.
Any dream Sandor may once have had for Ameribor to compete with Sofr ended long ago.
Sofr is the key interest rate benchmark. Average daily notional volumes of exchange-traded Sofr futures had reached over $6 trillion in the first quarter of 2023 as the end of Libor approached.
But as a risk-free rate based on secured overnight repo in US treasuries, it is not a particularly useful one for banks to price loans off.
Loans are credit instruments that must be funded, and not pure rates instruments.
The difference became most obvious in March 2020 at the outbreak of the Covid pandemic, when a flight to quality saw Sofr plunge, as investors rushed into Treasuries. Meanwhile Libor, which was still being used back then, rose sharply.
That sets a worrying precedent for a potential disconnect between collapsing income from banks’ floating-rate loan assets tied to Sofr and the rising cost of their own funding liabilities in any future systemic shock.
That is why 7Ridge is ambitious.
“There are 1,200 banks in the US with assets of more than $1 billion, so we still have a lot of room to grow,” Shay says. “Of course, the ideal would be to bring in one or more of the Home Loan Banks themselves, along with all their members.”
Conversations have been taking place with all sources of lenders to the AFX Marketplace since the 7Ridge acquisition.
Inverted pyramid
Regulators remain wary of blessing the widespread use in derivatives markets of any credit-sensitive rate derived from a small volume of interbank funding transactions but then benchmarking a much greater notional volume of financial contracts.
It was this the so-called inverted pyramid that, as much as its manipulation, led to Libor’s demise.
Banks continued to submit Libor quotes in the global financial crisis long after they had stopped lending to each other. The banks were the first to understand how rotten the whole system had become. They wouldn’t even lend to national champion banks overnight.
Given the moral degeneracy that characterized the banking industry in those days, it became almost inevitable that a fictitious rate – best described by former governor of the Bank of England Mervyn King as the one at which “banks do not lend to each other” – should be manipulated.
The end of Libor leaves open an important but difficult question: How much underlying funding volume is enough for a credit-sensitive rate to be deemed no longer the bottom of an inverted pyramid?
AFX says its marketplace has seen $2 trillion transacted since inception.
Right now, the Fed is paying a premium to the banks to maintain control of the price of money. It may be less keen to do that when the dragon of inflation is slain
John Shay
Bloomberg has enlisted some support for its Bloomberg Short Term Bank Yield (BSBY) index, derived from observed trades in unsecured bonds of the leading banks on its electronic bond-trading network.
On the back of these, it calculates theoretical one- three- nine- and 12-month funding rates. Bank of America even issued six-month floating-rate notes based off one-month BSBY back in 2021.
It remains to be seen if either or both BSBY and Ameribor gain widespread acceptance. Libor is gone and isn’t coming back. But the law allows US banks to benchmark loans against any replacement reference rate they deem appropriate to their own funding model and customer needs.
A marketplace in which banks lend unsecured overnight to each other sounds like it might be a good place to look for one.
The transformation of money markets in the era of higher-for-longer rates has barely begun. For now, central authorities want to keep control of the price of money and credit. But that comes at a cost: paying banks for the reserves they don’t lend out to the real economy.
“If the Fed were to reduce availability of overnight bank funding and force the banks to deposit their excess funds and to borrow in the open private markets, because banks are so oversupplied with both capital and liquidity right now, the free-market funding rate would probably be quite a lot lower than the OBFR,” Shay says. “So that would look like the Fed easing in an inflationary environment.
“Right now, the Fed is paying a premium to the banks to maintain control of the price of money.
“It may be less keen to do that when the dragon of inflation is slain.”
