SOFR

Replacing LIBOR

Publication of LIBOR―the London Interbank Offered Rate―will likely cease at the end of 2021. This is the message U.K. Financial Conduct Authority (FCA) CEO Andrew Bailey sent in 2017 when he announced that, after 2021, the FCA would no longer compel reluctant banks to respond to the LIBOR survey. Given the small number of underlying LIBOR transactions, and the reputational and legal risks banks face when submitting survey responses based largely on their expert judgement, we expect that most banks will then happily retreat. In just over two years, then, the FCA could declare LIBOR rates “unrepresentative” of financial reality and it will vanish (see, for example, here).

Most financial experts know this. Yet, LIBOR remains by far the most important global benchmark interest rate, forming the basis for an estimated $400 trillion of contracts (as of mid-2018; see Schrimpf and Sushko), about one-half of which are denominated in U.S. dollars (as of end-2016; see Table 1 here). While the use of alternative reference rates is increasing rapidly, to beat the LIBOR-countdown clock, the pace will have to quicken substantially. In the United States, the outstanding notional value of derivatives linked to the alternative secured overnight reference rate (SOFR) jumped from less than $100 billion to more than $9 trillion in just the past year (see SIFMA primer). Yet, this amount still represents a small fraction of outstanding dollar-LIBOR-linked instruments.

In this post, we examine the U.S. dollar LIBOR transition process, highlighting both the substantial progress and the major obstacles that still lie ahead. The key goal of the transition is to ensure that the inevitable cessation of LIBOR does not trigger system-wide disruptions. Unfortunately, at this stage, count us among those that remain deeply concerned….

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The Brave New World of Monetary Policy Operations

Prior to the Lehman failure in 2008, the Federal Reserve controlled the federal funds rate through open market operations that added to or subtracted from the excess reserves that banks held at the Fed. Because excess reserves typically were only a few billion dollars, the funds rate was very sensitive to small changes in the quantity of reserves in the system.

The Fed’s response to Lehman and its aftermath included large-scale asset purchases that led to a thousand-fold increase in excess reserves. Consequently, since 2008, small open-market operations of a few billion dollars no longer alter the federal funds rate. Instead, the Fed introduced administered rates to change its policy stance. The most important of these—the interest rate that the Fed now pays on excess reserves (IOER)—sets a floor below which banks will not lend to other counterparties (since an overnight loan to the Fed is the safest rate available).

Until very recently, the Fed’s ability to control the federal funds rate seemed well in hand….

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Alternative Reference Rates: Meeting the Challenges

Guest post by Richard Berner, Executive-in-Residence (Center for Global Economy and Business) and Adjunct Professor, NYU Stern School of Business

In response to the fragility of LIBOR and other interest-rate benchmarks, regulators globally are working with industry to identify sturdy alternatives. Despite significant progress, concerns persist that the transition to these new reference rates will be disruptive.

While these concerns are legitimate (see Eclipsing LIBOR), both U.S. and global authorities and market participants have begun to address them in ways that should go a long way to managing the risks. In this post, we review why LIBOR’s persistent fragility makes reform critical, and examine progress on some of the ongoing reforms....

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Eclipsing LIBOR

The manipulation of the London Interbank Offered Rate (LIBOR) began more than a decade ago. Employees of leading global firms submitted false reports to the British Banking Association (BBA), first to influence the value of LIBOR-linked derivatives, and later (during the financial crisis) to conceal the deterioration of their employers’ creditworthiness. U.S. and European regulators reported many of the details in 2012 when they fined Barclays, the first of a dozen financial firms that collectively paid fines exceeding $9 billion (see here). In addition to settling claims of aggrieved clients, these firms face enduring reputational damage: in some cases, management was forced out; in others, individuals received jail terms for their wrongdoing.

You might think that in light of this costly scandal, and the resulting challenges in maintaining LIBOR, market participants and regulators would have quickly replaced LIBOR with a sustainable short-term interest rate benchmark that had little risk of manipulation. You’d be wrong: the current administrator (ICE Benchmark Administration), which replaced the BBA in 2014, estimates that this guide (now called ICE LIBOR) continues to serve as the reference interest rate for “an estimated $350 trillion of outstanding contracts in maturities ranging from overnight to more than 30 years [our emphasis].” In short, LIBOR is still the world’s leading benchmark for short-term interest rates.

Against this background, U.K. Financial Conduct Authority CEO Andrew Bailey, recently called for a transition away from LIBOR before 2022 (see here). In this post, we briefly explain LIBOR’s role, why it remains an undesirable and unsustainable interest rate benchmark, and why it will be so difficult to replace (even gradually over several years) without risking disruption.

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