Credit‐Sensitive Rates: Opportunities and Risks in the Post‐LIBOR Era

As potential alternatives to the London Interbank Offered Rate (LIBOR) that ceased to be published in June 2023, credit‐sensitive rates (CSR) were developed in addition to the overnight risk‐free rates, like the Secured Overnight Financing Rate (SOFR). These CSRs namely contain a credit component and are thus more similar to LIBOR in capturing the credit risk component of unsecured bank borrowing compared to overnight risk‐free rates. Based on an analysis of existing academic literature, press reports, and analyses from regulators and administrators, this article examines the question of whether CSRs should be encouraged or rather be avoided under the current market circumstances. This article highlights the potential advantages of these rates, such as their usability for asset‐liability risk management and hedging purposes, but warns of the risks attached to them. That is, CSRs are mostly based on short‐term money‐market instruments, like commercial paper and certificates of deposit, and liquidity in these financial instruments was almost non‐existent during previous market stress events, like the COVID‐19 financial crisis. These benchmarks could thus suffer from the same weaknesses as LIBOR in that they may represent a rather inactive underlying market. CSRs are not illegal and can thus be freely used in the US, but users should consider utilising them prudently.