Jim Kharouf – John Lothian News
The American Financial Exchange (AFX) is set to list its first Ameribor futures products – 3-month and 7-day Ameribor futures – on August 16, 2019, the 42nd anniversary of the launch of Treasury bond futures. John Lothian News contributing editor Jim Kharouf sat down with Richard Sandor, chairman and CEO of AFX, to talk about new contracts, how the interest rate benchmark space is evolving and why now is the time for a new interest rate contract.
Sandor knows plenty about starting new markets, from listing the first interest rate contracts on the Chicago Board of Trade in the 1970s to launching the Chicago Climate Exchange (CCX) in 2003 as the first U.S. emissions cap-and-trade market for all six greenhouse gases. After creating a viable spot market with AFX beginning in 2015, Sandor’s now says it is time to build futures markets for the US’s regional, mid-sized and community banks, which collectively hold $9 trillion in assets. This could reset the way banks set rates and create new products from credit cards to commercial loans.
Q: You’re set to launch Ameribor futures on August 16, the 42nd anniversary of the launch of the Treasury bond futures contract. What similarities do you see in the two markets and products 40-plus years later and what’s new?
A: The similarities are that both contracts are a segue into a very different world. In the case of Treasury futures, it was a propitious time because interest rates were quiescent. The markets for Treasuries were inefficient. There were only 18 billion Treasuries cumulatively issued by the US government in August 1977. You compare that to the 2 7/8ths which just reopened with 16 billion, and add it to the previous amount of 41 billion. So this one coupon with Treasuries is three times the size of the cumulative issues of the US government in 1977.
They were launched also with the expectation that interest rates would become more volatile and a hedging mechanism was really needed. Also in anticipation that we would ultimately pay the price for deficits and debt built for the Vietnam War. There was also the belief that transparency would be good for all by tightening the bid/ask spread.
I think we’re in a similar situation here where there is a structural change going on. We started AFX in 2011 thinking that it would be a 10-year journey. By pure fortuity, 2021 is when LIBOR will officially end. In addition, when Treasury futures were launched, we were still two years away from former Fed Chairman Paul Volcker’s “Saturday Night Massacre” when the Fed allowed interest rates to fluctuate. And it’s going to be a couple of years until LIBOR ends. It’s amazing because it is the same horizon that existed at that time.
Most importantly, it’s viewed as early, as Treasury futures were. And to be on time, you have to be early. It took four years of research to launch the American Financial Exchange. We’re executing our strategy now once we built a critical mass in the spot market so we could ultimately launch a futures market. That allows banks to hedge in an instrument that reflects their unsecured borrowing costs. Most importantly, our banks, which are the regional, midsize and community banks, borrow every day in Ameribor. Now they’ll be able to hedge it. Once they hedge it, you can expect to see floating rate loans, credit cards, mortgages and even debt to emerge. And that will build the open interest in the nearby and more distant contracts.
Q: When you look across the evolving interest rate benchmark space, Libor is going away and SOFR is coming, and Ameribor has gained momentum. Why is now a good time to launch these contracts?
A: It’s very important to address the perception that the world should have one interest rate benchmark. LIBOR is an anomaly. It is the only asset class I know of with only one benchmark. In the commodity area, you have West Texas Intermediary and Brent crude, Dubai and Shanghai. And in equity markets, you have the S&P 500, Dow Jones, Nasdaq, Russell and Value Line. You have more stock indexes than you have stocks. And in fixed income, you have governments, munis, corporates and long-term, short-term. And now the world is asking, what is the substitute for LIBOR? It’s not the proper question. We live with three wheat contracts – cookies, bread and pasta. And no one would ever hedge pasta in the cookie market, nor hedge cookies in the bread market. It’s a well-known fact that you can have simultaneously different futures to identify different markets. So one infers from history that multiple benchmarks will emerge, and that’s already happening. You have SONIA, SOFR, Japanese and Canadian benchmarks. It’s already here.
So why now? Ultimately, we need a new unsecured rate and a rate that is good for 5,000 banks that don’t own government (securities) and borrow unsecured. If they are to do asset management and asset liability management, and borrow unsecured, they should be creating assets that are tied to the unsecured rate. There can be alternatives. We thought the best way to do that is to launch futures.
Q: I’ll push it a step further. What are some of the pieces that are now in place for a futures contract launch?
A: There are five conditions that exist. You need a competitive market, price movement and therefore the need to hedge. And you don’t have to look very far to see that interest rates move, or see a cash market with critical mass. Our one-week contract reflects that need to hedge because of the minimum reserve requirement that the Fed is giving out every two weeks. The one-week contract really allows banks to hedge and be in compliance with FRB 2900, which is the minimum reserve requirement. We think we have natural hedgers for that product. The goals are set by the government every two weeks, and a weekly contract allows them to hedge all of it or a week at a time, depending on deposits, in-flows and out-flows. So it is perfectly designed to meet a hedging need. The 90-day is more self-evident, because that’s a rate that will be used to hedge loans, credit cards, adjustable rate mortgages and things of that nature. The hedging need is driven by central bank requirements and an alternative mechanism for people who start using Ameribor.
In addition, the real critical element is education to make sure the cash market is being facilitated by infrastructure. What do I mean by that? We are certified IOSCO compliant. For banks to tell their customers and for international recognition, we follow the 19 core principles that include transparency, anti-manipulative rules and so on. The spot market is transparent. We’re the only market that you can see time and sales for the entire spot market. You can’t see that in any other market. In equities, you only know that 10,000 Apple shares are trading at XYZ. You don’t know what is above and below the market. So we’re going to be the most transparent spot market anywhere because we are not an agent spot market. The more transparent you can be, the better off everybody is.
Q: What is the trading opportunity here for participants as hedgers or speculators?
A: For certain people who want to do event risk, the one-week contract will give you more precision on the likelihood the Fed is going to increase or decrease. The whole question of sorting out credit premium for Fed Funds, you’ll now get a measure of credit spreads within the interbank market. So for hedgers it’s clear.
For traders, the real question is going to be, what are the real relationships that are market driven and totally transparent between and among Ameribor, SOFR, eurodollars, Fed Funds, all of which can be transactionally effective on organized, transparent futures markets? We believe the more futures there are, where you can express an interest rate opinion relative to other interest rate opinions, is going to make both markets more efficient just as arbitrage always does.
Maybe the markets will be totally efficient from day one. But I would be totally surprised if there weren’t anomalies. In Treasury bonds, you could buy the cheapest to deliver and sell the bond and make a point. And that still, while doing that, was efficient for everybody. The arbitrage provided the liquidity and the liquidity provided for the hedgers to operate as long as the basis remained cheap for a long time. Hedgers were able to execute with more liquidity and without a basis loss. The same exact thing happened in Eurodollars. The one-year strip traded at over 100 basis points from the one-year deposit and that persisted. Even Fed Funds, in the early days, you had hypothetically a particular contract – say May where you priced in a rate cut and June didn’t. So you could buy May and sell June because it wasn’t efficiently priced.
Q: What needs to be done now, with market makers, education of members and so on?
A: The bucket list is phenomenal and I feel like I am carrying two buckets, each with holes in them. We have market readiness meetings every other day. So for our members, are they ready? Do they have risk management practices? Many haven’t ever used it. We have an exchange package of 120 pages for the risk management as a template and guideline. We don’t expect them to adopt it, but it has proven a good framework for their lawyers and risk managers to follow. And what does an FCM need? How many confirms do you need so traders do not have to make margin calls? This stuff we regard as routine. So there is stuff that is readiness for those who have never before used the market.
And there is readiness for those who have used it, and you have to educate them. You have to educate the lawyers about futures, the accountants about hedge accounting and what that means, the press and academics because they will be writing about it. We’re now formally creating an academic advisory committee for academics who want to look at our order book. It’s never been studied before. We’ve already had Federal Reserve economists ask if this data is going to be available And the answer is yes.
Last summer we went to an MIT and University of Chicago conference with 75 newly minted PhDs in economics. What are you teaching in your course and how do benchmarks fit in? Then you need to bring your message to local universities. What are you teaching your students? You have the press, academics and students, lawyers, accountants and then of course, regulators. You have to go to the CFTC of course, but also the Fed, OCC and FDIC to inform them. There are hundreds of little dials that need to be calibrated to do it. And then go to IOSCO to tell them what we are doing and how we satisfy the 19 core principles and what you can do. It’s more art than science. We’ll make some mistakes but we won’t make the obvious ones because we’ve been to this rodeo before.
We know, once you advocate a transformational change of the size we have, you bring in a level of education that has to meet the transformational objective you have. We know it because of Treasury bonds and climate markets. We’re educating the 5,000 non-SIFI banks that represent $9 trillion. That is pretty monumental. You have to educate the loan officers and the customers. And then you have to educate the industrials on how to price commercial paper. If you are using LIBOR. How about when LIBOR goes away? Have you thought about that?
The transition and why we’re happy to exist in a SOFR world, is that SOFR and Ameribor are complementary and not competitive. All of the work that SOFR and the Alternative Reference Rates Committee (ARRC) is doing helps Ameribor because of the need to transition from LIBOR. To make that orderly transition, we have to make sure it is like Y2K.
Q: That is a long list.
A: Yes, and it is just the beginning. We have an event planned at the Union League Club in Chicago to educate. We’ll have to do it in New York and in London at some time because of the amount of dollar trading and Brexit. We may do it in Frankfurt, Amsterdam and Paris. We’ve already had interest from European and Chinese bankers asking, “What about a local rate like Ameribor for our sovereigns?”
Q: What’s next for AFX in terms of new products?
A: We’ll ultimately look to do an ETN or an ETF and get our members to issue Ameribor-based loans. Also, we’re starting to educate the swap dealers. We have a whole new audience to educate. It’s not only big banks but so many of our banks perform a risk management function of offering swaps to the smaller banks. You have all of the swaps dealers, all of the regional banks and dealers. And we’re also trying to be inclusive. By that I mean we set out to try to address the concerns of regional, midsize and community banks, but also to promote diversity. We now have African-American banks, Latino banks, Korean and Chinese banks, all which are called minority-owned banks by the FDIC. We also made an effort to recruit banks with female CEOs for gender diversity. So we’re trying to paint a big rainbow of not just those 5,000 banks but the minority-owned banks as well.
If that’s not enough for this small company, I don’t know what is. We’re stretched as wide as we can. We want Ameribor to be the people’s rates.