Preparing for a world without Libor

William Dudley, Former President of NY Fed in this important speech says how we need to prepare for a world without Libor.

The reference rates are important but Libor has serious defects:

Broadly speaking, reference rates are vital to efficient market functioning.  They facilitate trading in standardized contracts, which lowers transaction costs and increases market liquidity.  Robust reference rates can also reduce information asymmetries and the risk of misconduct by providing transparent, independent pricing. 

But, in the case of LIBOR, the foundation had serious flaws.  Most notably, LIBOR was (and is) based on submissions from individual banks—which, in turn, were based on hypothetical borrowing rates or expert judgments, and not actual transactions.  Moreover, deficiencies existed in regulatory oversight and governance of the rate-setting mechanism.  These vulnerabilities enabled the manipulation of the rate for the financial benefit of individuals and institutions.  Amid profound breakdowns in controls and compliance, individual traders conspired with rate submitters at their own institutions or traders at other firms to manipulate the setting of the rate to improve their trading results.  During the global financial crisis, panel banks also reportedly submitted lower borrowing rates than they could actually obtain in the marketplace.  They did so to disguise their financial fragility at a time when uncertainty over bank liquidity and solvency was high.3  

The resulting scandal was particularly disturbing because of its scale and flagrancy, including collusion by employees across firms.  It led to billions of dollars in fines, jail terms for some individuals, and severe reputational damage to the financial industry as a whole.  The global financial crisis exposed excessive risk-taking and a long series of lapses in judgment, and the LIBOR scandal further undermined trust in the ethical standards of the banking industry. 

The scandal provides many cautionary lessons, including the ways in which poor technical design can be exploited, the limitations of self-regulation, the problems that arise when loyalty is to one’s trading co-conspirators rather than to one’s institution, and the need for robust controls.  It also underscores the power of incentives to drive individuals and firms to do things that are imprudent and/or unethical.4 And, the governance and control framework that the banks and the LIBOR administrator had in place proved woefully insufficient to prevent misconduct that stemmed from poor incentives.  In this context, one could say it was a situation ripe for exploitation. 

The openness and brazenness of misconduct as captured in the recorded transcripts also point to serious deficiencies in bank culture. 

Fed has established an Alternative Reference Rates Committee (ARRC):

The Federal Reserve has played a lead role in the development of these recommendations as applied to U.S.-dollar LIBOR, working closely with the other major financial regulatory agencies in the United States.  This effort has also involved coordinating with the official sector sponsors of similar efforts around the world.15   In late 2014, in response to FSB and Financial Stability Oversight Council recommendations, the Federal Reserve convened the Alternative Reference Rates Committee (ARRC)—a group of market participants established to identify more robust alternative U.S.-dollar reference rates that are risk-free or nearly risk-free, fit the needs of the derivatives market, and are compliant with IOSCO principles.16   This effort paralleled similar ones in other jurisdictions to find reference rates that are well-suited to local conditions and market needs—including the UK’s Working Group on Sterling Risk-Free Reference Rates.  The ARRC was also tasked with developing a transition plan to facilitate the adoption of these rates in a voluntary and orderly manner, and with considering best practices in contract design to prepare for the possibility that LIBOR ceases to be published.

This has led to a new reference rate in US:

The ARRC has made important progress in achieving its mandate.  Notably, in June 2017, it selected the Secured Overnight Financing Rate, or SOFR, as its preferred alternative to U.S.-dollar LIBOR.  SOFR is a broad measure of the cost of borrowing cash overnight using U.S. Treasury securities as collateral, and is thus relevant to a wide range of market participants.  The rate is entirely transaction-based, and the underlying market is robust, with current daily volume of more than $700 billion.  (By comparison, unsecured three-month U.S.-dollar wholesale borrowing totals roughly $1 billion per day, as I mentioned earlier.)  SOFR moves closely with LIBOR and other money market rates over time, and because it covers multiple segments of the repo market, it provides scope for future market evolution.17   Besides being more resistant to manipulation, this nearly risk-free rate should also prove much more resilient during periods of financial stress, because the U.S. Treasury repo market is likely to remain deep and active during such episodes. 

The New York Fed administers and produces SOFR in cooperation with the Office of Financial Research.  We began publishing this rate on April 3 of this year, along with two other repo rates: the Tri-Party General Collateral Rate and the Broad General Collateral Rate.18   This work complements steps by the Federal Reserve to promote greater transparency in rates in unsecured markets through enhancements to the calculation of the effective federal funds rate (EFFR) and the launching of an entirely new rate, the overnight bank funding rate (OBFR).19 

SOFR data is here.

Hmm.. Lots happening and to figure…


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