Beyond Libor: The Evolution of ‘Risk‑Free’ Benchmarks

The how of transitioning to a new or revised benchmark rate will be as critical as defining what the new benchmark should be.

Changes may be on the horizon for short-term transactions traditionally pegged to the London Interbank Offered Rate (Libor).

The Libor-fixing scandal that emerged during the financial crisis revealed some limitations in Libor’s use as a benchmark, including the possibility of manipulation and a declining transaction volume from which to draw reporting data. And recent regulatory efforts – predominantly money market reform – have lent some urgency to the push for the impartial evaluation and selection of an alternative “risk-free” reference rate.

Current monetary policy has dramatically changed the way investors and central banks think about how money is exchanged. And given the sheer numbers of investments and contracts keyed off Libor (floating rate notes, bank loans, personal loans, swaps, etc.), the how of transitioning to a new or revised benchmark rate will be as critical as defining what the new benchmark should be.

Evolving benchmarks

Historically, short-term markets and related instruments have relied on a set of benchmarks that emerged from the evolution of the markets themselves. For example, the federal funds rate became the benchmark for the Federal Reserve’s target rate and remained so for several decades. More recently, it was effectively replaced by the corridor rate structure of interest on excess reserves (IOER) and the Fed’s fixed-rate reverse repo program (FRRP).

Libor is undergoing a similar evolution. Originally established in the mid-1980s as a proxy benchmark for average AA rated interbank funding levels, the authenticity of the underlying data has since come into question. And banks’ declining appetite for wholesale unsecured short-term funding – resulting variously from the fixing scandals, trading liabilities, reductions in repos and a rise in commercial paper issuance – has only underscored these limitations. Without sustainable trading volumes and liquidity, price discovery in unsecured short-term markets would remain uncertain and opaque. This, in turn, hurts the credibility and reliability of the benchmarks, specifically Libor, that rely on them.

Finding alternatives

Over the past few years, regulators and market participants have made several recommendations for ensuring that benchmarks reflect banks’ funding conditions more accurately. The UK’s Financial Services Authority (FSA) led the first substantive effort in 2012 with its “Wheatley Review,” which sought to outline specific criteria for participating banks to submit their daily Libor levels.

But this was only an initial step. In the U.S., the Financial Stability Oversight Council (FSOC) and the Financial Stability Board (FSB) suggested further reviews of short-term benchmark rates to ensure their authenticity and prompted the Federal Reserve to convene the Alternative Reference Rates Committee (ARRC) in November 2014. The ARRC consists of representatives from major banks participating in the over-the-counter (OTC) derivatives market, their respective regulatory supervisors, and representatives from major central banks. 

The Fed’s specific objective for the ARRC is to consider potential “risk-free” (or nearly risk-free) alternative rate indexes that would replace Libor and offer greater breadth of observable trade activity. More specifically, this group must consider:

  • The migration from a (financial) credit-linked benchmark to one that is risk-free and representative of observable interdealer/interbank market activity
  • Developing an alternative to the overnight indexed swap (OIS) rate referenced by derivatives contracts and central clearing parties (CCPs)

Since the initial meetings in 2014, the ARRC has narrowed its list to two potential alternatives:

The overnight bank funding rate (OBFR)

The OBFR is a volume-weighted median average rate of both overnight fed funds and eurodollar transactions, which average $70 billion and $240 billion per day, respectively, and encompass data submitted from financial institutions beyond the scope of the Libor-submitting banks.

Additionally, the OBFR would provide greater diversity of reported results. The ARRC reports that a single government-sponsored enterprise (most likely the Federal Home Loan Bank Board) is the lender behind over 90% of overnight fed fund transactions, and half the proceeds go toward funding the Fed IOER arbitrage trades by many “Yankee bank” financial institutions. 

With the forthcoming higher regulatory capital requirements for foreign banks, the Fed arbitrage trade will be less profitable, and the transaction volume in the fed funds market can fall dramatically in times of stress. We believe the OBFR should prove more resilient and stable than Libor given its wider set of potential observations.

The overnight Treasury general collateral repurchase agreement (GC repo) rate

An index based on the GC repo rate is also viable. Although the ARRC has identified the overnight repo market as a source for a potential alternative index, it has not yet identified a specific rate to target. While there are currently several private alternatives based on the tri-party GC and general collateral financing (GCF) markets, the ARRC has expressed some preference for a rate produced by the public sector. 

What’s next for investors?

Global investors’ proactive consideration of ongoing structural changes in markets has become critical for successfully navigating the current investment paradigm. Whether it’s adapting to money market reform, stimulative monetary policy or increased bank capital and liquidity requirements under Basel, market participants must balance the search for returns with stability while navigating the shifting tectonic plates of the investment landscape.

We view regulators’ continued push for a more resilient short-term benchmark based on robust and observable contributing data as a necessary step in this evolution of modern global financial markets – and while not a quick fix, we believe it will eventually result in a stronger and more resilient financial system that benefits issuers and investors alike.

While the formal results of the ARRC’s effort and the eventual implementation of its benchmark recommendations are still a few years away, it is never too early for investors to begin considering how the changes will affect them. We believe the key will be planning for the transition: The financial, legal and operational considerations during the transition from Libor will likely be considerable, and investors will need to understand the composition of the new benchmark to protect their interests during the process.

The Author

Jerome M. Schneider

Head of Short-Term Portfolio Management

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