Download Beyond Libor: The Evolution of `Risk-Free` Benchmarks

VIEWPOINT
November 2016
AUTHORS
William G. De Leon
Managing Director
Global Head of Portfolio
Risk Management
Beyond Libor: The Evolution
of ‘Risk-Free’ Benchmarks
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
Jerome M. Schneider
Managing Director
Head of Short-Term
Portfolio Management
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.
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November 2016 Viewpoint
FINDING ALTERNATIVES
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:
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 shortterm 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-thecounter (OTC) derivatives market,
their respective regulatory
supervisors, and representatives
from major central banks.
• 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 governmentsponsored 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.
November 2016 Viewpoint
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 shortterm 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.
“The financial, legal and
operational considerations
during the transition
from Libor will likely
be considerable.”
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.
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