Options Innovation

Trading begins today on the new American Financial Exchange (AFX), an overnight market for interbank loans. The startup exchange seeks to create a market in a new financial index, Ameribor.

AFX hopes to establish its patented American Interbank Offering Rate as a commonly used benchmark interest rate for loans and trading products. The rate would be established through a market auction of banks making bids and offers through the AFX on loans from other banks. The benchmark and exchange are targeted to the approximately 6,000 small and mid-sized banks in the United States.

The current benchmark for interbank loans is the widely used and reported London Interbank Offered Rate (Libor). Libor is determined by a survey of the rates used by the largest banks for interbank lending and has come under increasing fire over the past decade for rate fixing among survey banks.

Benchmark interest rates have been created in other markets, including Europe and China, in recent years. “The world’s largest market does not have a rate,” said Dr. Richard Sandor, AFX chairman and CEO. Dr. Sandor spoke Thursday Dec. 10 at the third annual Options Alliance conference in Chicago.

In looking at the Libor rate-setting scandals, which have resulted in record fines and criminal charges, the AFX group noted that the rates are not set through a trading market mechanism of bids and asks. The question they asked: How would we do this if we could start from scratch?

The answer they came up with was to establish an auction market for small and mid-sized banks. AFX chose to focus on small banks, in part, because of the key position they play in the U.S. economy. “I am unambiguously convinced that the small banks socially are undervalued,” Dr. Sandor aid. “The important thing is for us to cherish them. Who is lending to a farmer for his Caterpillar tractor?”

The international financial infrastructure and its benchmark rates are designed for the large global banks, not the smaller banks lending to local small businesses. Asset-liability management for small banks is hampered by an index like Libor, as the rate may not change, leading to basis risk.

At the same time, the market for interbank lending has been weak. Given the current low interest rate set by the Board of the Federal Reserve, it is less costly for banks to borrow from the Fed rather than one another. The interbank lending that does occur is conducted the old-fashioned way. “To our surprise, interbank borrowing and lending is still conducted the same was as in the 1980s,” Dr. Sandor said. “It’s a voice-brokered market.”

AFX is organized as a virtual electronic exchange with the Chicago Board Options Exchange (CBOE) providing the infrastructure and compliance. The Northern Trust serves as the settlement bank.

Timing of the AFX launch is fortuitous as the Fed’s Federal Open Market Committee meets this month and is widely expected to increase its baseline interest rate for the first time since June 2006. Market acceptance of Ameribor as a widely used and traded index, however, would take much longer. “It takes five to 10 years to make a market work,” Dr. Sandor said.

He is in a position to know. Considered a legend in Chicago trading, Dr. Sandor is called the “father of derivatives” for his work in establishing futures trading in the 1970s. He is also the founder of the Chicago Climate Exchange (CCX) and other environment-based trading systems.