Environmental Financial Products, headed by financial-futures guru Richard Sandor, is teaming with options-exchange operator CBOE Holdings to launch American Financial Exchange, an electronic marketplace for small and mid-sized banks to lend and borrow short-term funds.

“We are pleased to bring this exciting concept to life,” CBOE Chief Executive Officer Ed Tilly said on a conference call to discuss the venture. “The ability to bring transparency, price efficiency and transaction-based benchmarks to interbank lending is a groundbreaking opportunity.”

AFX is meant to bring the benefits of electronic exchange trading, such as standardization, transparency and a rules-based process, to interbank lending, while reducing transaction costs. The new marketplace will also generate a transaction-based interest rate benchmark through weekly auctions of Ameribor, a new benchmark rate for U.S. interbank lending.

Sandor said on the conference call that AFX is a product of more than three years of research that started when he observed that benchmarks didn’t necessarily reflect the true funding costs of small and medium-sized banks. “With AFX, we think we can fill a void for these banks by creating a centralized electronic market,” he said.

CBOE, best known for its CBOE Volatility Index (VIX), will host and operate AFX, which is slated to launch in the fourth quarter. Lending by small and mid-sized banks represents about 35% of all business loans in the U.S., Sandor noted.

AFX’s first ‘bucket’ will be for overnight and 30-day lending, which combined run at about $55 billion per day, Sandor said. This should find greater demand as the U.S. Federal Reserve commences raising interest rates, which is expected as soon as this year.

“We think that someday in America, interest rates might rise,” Sandor said. “This is a propitious moment to launch something that will help banks in their asset-liability management.

The second bucket will be a weekly auction that will compile bids and offers and hit out to an Ameribor benchmark rate. “The first alternative creates liquidity for interbank markets,” Sandor said. “The second will be a benchmark that can be an asset management tool.”

Sandor, who pioneered the development interest rate futures contracts in the 1970s and later founded an exchange that matched trades of emission credits, said he is “more excited about this (AFX) product than any other product in 50 years.”

AFX will focus on 1,740 community and regional banks with between $500 million and $125 billion in assets, which hold a combined $4.7 trillion in assets.

Currently in lending between small and medium-sized banks, “there’s a bilateral market and no screen,” Sandor said. “We will hopefully do for banking in the interbank market what was done with Treasuries and the government market — reduce borrowing and lending costs and collapse bid-ask spreads.”

Feature image by Intararit/Dollar Photo Club