Risk of Derivatives – The Fall of an Index

There are many historical examples of some sophisticated and some less sophisticated entities imploding from the risk of derivatives.  Barings Bank, Orange County (CA), Enron, Long-Term Capital Management, and other entities misused derivatives or didn’t understand the difference between hedging and speculating.  Some bankers will soon hear about another example of banks using derivatives that, unfortunately, will lead to losses.

Risk of Derivatives – BSBY Discontinuation

Bloomberg L.P. introduced a LIBOR alternative in March of 2021 (called BSBY).  At that time, we believed that the stated benefits of BSBY over LIBOR were questionable, and we decided not to adopt BSBY for any of our hedge products or as an index for our loans.  Bloomberg recently announced that it will shut down its BSBY index on November 15, 2024.  The reason for the cessation of BSBY is simple – lack of use.  With the development of the term SOFR market, BSBY offers no perceived advantages over SOFR, Fed Funds, or Prime.  BSBY was not well received by US regulators from its inception, but the market eventually embraced SOFR over BSBY.  BSBY futures trading volume is close to zero, and open contracts are less than 3k across all BSBY maturities (compared to robust volumes and outstandings for SOFR).

Unfortunately, some banks adopted BSBY as one of their preferred indexes and in doing so created risk in derivatives and operations.  With the demise of BSBY, those banks that used the index to hedge their interest rate risk will now be dealing with potential losses.  Comerica Bank announced a $91mm charge, and Bank of America announced a $1.6B charge related to the discontinuation of BSBY and the resulting “de-designation” of certain balance sheet swaps.  There will likely be other banks that adopted BSBY that will take similar charges.

We highlighted this risk of derivatives as we had concerns about BSBY. We published various articles comparing community bank alternatives to LIBOR (such as SOFR, Ameribor, Fed Funds, and Prime).  We believe that daily and term SOFR offer community banks the safest and most dependable index for benchmarking profitability, pricing loans, and hedging interest rate risk.

Hedging Vs. Speculation

The most potent example of hedging vs. speculation is our ARC program.  Historically, community banks have hesitated to adopt derivatives for several reasons.  The documentation was lengthy and complex, the regulatory compliance and reporting was cumbersome, the accounting was tricky, and the overhead cost of launching a hedging program was challenging.  Most importantly, community banks found it difficult to sell the product to their average customer.  If you only sell a few loan hedges yearly, are the startup and maintenance costs worth it?

At SouthState Bank, we use an alternative to ISDA-based, back-to-back swaps.  We believe that our program offers an advantage against the national banks.  The ARC program has the following benefits to the community bank lender and the borrower, as follows:

• Only a short (4-page) and simple addendum to the promissory note as additional documentation. No ISDA documents.
• No additional reporting or regulatory compliance for the lender or the borrower.
• No derivative accounting for the lender or the borrower.
• Virtually no ongoing or upfront costs.
• We provide lenders with education and marketing support to sell the ARC program.

We offer term or daily SOFR as the hedged index.  The ARC hedge mirrors the loan terms exactly – accrual, payment frequency, principal amount, and payment dates all match.  The result is that the borrower is invoiced with one bill each payment period for the same P&I dollar amount.  Therefore, the payment amount creates the equivalent of a fixed-rate note experience for the borrower.  On the spectrum of hedging vs. speculation, we believe that the ARC program is on the hedging extreme because the community bank allows the conversion of a floating rate note into a known payment, decreasing the borrower’s credit and interest rate risk.

Conclusion

The BSBY case study highlights one of the often-overlooked risks of derivatives. Banks need to consider the index’s liquidity and longevity when indexing loans or hedge instruments.

If your bank is facing borrower demand for fixed-rate term loans, your bank does not want the interest rate or credit risk, and boosting interest and fee income in 2024 are essential to you; the ARC may be a solution for your customers.  SouthState Bank uses the ARC Program as a solution for our commercial borrowers.  It delivers all of the benefits of loan hedging without the encumbrance of the accounting, compliance, and documentation hassles.