(Bloomberg) -- Over a decade ago, Scott Peng was one of the earliest voices to call out the scandal-ridden London interbank offered rate. Now, he’s sounding the alarm over its successor.

Peng says guidelines designed to limit who can use derivatives tied to the Secured Overnight Financing Rate are inadvertently heaping risk onto banks’ balance sheets, echoing warnings from TD Securities and JPMorgan Chase & Co. Left unchecked, he says, it could pose a significant risk to the smooth functioning of financial markets.

“Banks and issuers are just starting to come to grips with this — we are at the beginning of a reckoning,” said Peng, chief investment officer of Advocate Capital Management. In 2008, as the former head of Citigroup Inc.’s US rates strategy team, he was among the first to suggest that Libor was understating borrowing costs, helping spark investigations that revealed rampant manipulation and ultimately contributed to the benchmark’s demise.

“At the present time it’s an annoyance, but as that risk position becomes bigger and bigger at some point it becomes a systemic issue.”

At the heart of the matter is the decision by the Alternative Reference Rates Committee — the Federal Reserve-backed body overseeing the transition from dollar Libor — to effectively restrict who can use forward-looking term SOFR swap contracts, which let two parties exchange fixed and floating-rate cash flows over a set period. For the most part, only firms that issue floating-rate debt tied to term SOFR itself, like leverage loans or collateralized loan obligations, can use the derivatives. That’s partly because officials don’t want markets to overly rely on term benchmarks that lack significant underlying liquidity.

Many companies that borrow in the $1.4 trillion leveraged loan market offset their interest-rate risk (SOFR moves practically in lockstep with Fed funds) by entering into swaps contracts with banks, paying a fixed rate and receiving a term SOFR rate. The trouble arises when banks then try to hedge their end of the trade. Corporate borrowers on the other side of the coin — those looking to switch from fixed- to floating-rate funding — were once reliable counterparties, but they can’t enter into paid term SOFR swaps, given the ARRC’s recommendations. 

Instead banks can only offer swaps derived from overnight SOFR, creating what’s known as ‘basis risk’ on their balance sheets, the result of the mismatched hedges. Peng says that large Wall Street dealers already stand to lose between $5 million and $10 million if the spread between overnight and term SOFR moves against them by just one basis point, and their exposure is growing with every new transaction. 

“If the risk gets big enough I can certainly see banks stopping traders from doing more of this,” Peng said.

A representative for the ARRC declined to comment, referring Bloomberg to a readout of the group’s most recent meeting, in which it reiterated its existing best practice recommendations while noting that the committee plans to continue to assess the use of term SOFR going forward.

CME Group Inc., the exchange operator that administers term SOFR rates and whose licensing requirements for derivatives are aligned with the ARRC’s best practices, declined to comment.

Three-month term SOFR rose to 4.6855% from 4.6817% in the prior session, CME Group data show. 

‘Risk Issue’

Peng’s warnings echo those of JPMorgan’s Alice Wang and TD strategist Priya Misra, who in recent months have flagged the accumulation of basis risk by banks as well as the rising cost to borrowers as dealers charge them more to fix their floating-rate obligations using forward-looking SOFR swaps.

As a result, investors will have to decide about the tradeoff between paying the basis or leaving the risk unhedged, Misra said. 

The ARRC, for it’s part, has been clear about why it recommends most firms avoid term SOFR derivatives, noting that it wants to prevent “use that is not in proportion to, or materially detracts from, the depth of transactions in the underlying derivatives markets that are essential to the construction of the SOFR term rate over time.”

Regulators are also eager to avoid any real or perceived impropriety linked to SOFR, given Libor’s failings. The widespread use of term risk-free rates in derivatives could create conflicts of interest among market participants trading actively in both overnight and term contracts, according to a 2021 report from the Financial Stability Board.

Yet Peng warns that without changes to liberalize the usage and clearing of term SOFR swaps, the problem is likely to worsen.

“It’s a risk issue,” Peng said. “Banks are accruing this basis risk on their books. If this continues the spread will widen and widen further. Their existing basis position is going to lose money.”

--With assistance from Jeannine Amodeo and Matthew Boesler.

(Corrects description of CME Group in 10th paragraph)

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