Libor refuses to die, setting up a $370T benchmark battle
Astruggle that will dictate the future of financial markets is brewing. Long beleaguered Libor is fighting to preserve its status as the premier global benchmark for dollar-based assets just as questions pile up over the credibility of its presumptive heir.
It’s a clash with few equals in financial history. In one corner, the much maligned set of Londonbased rates that, even after being tainted by rigging scandals, still underpin more than $370 trillion of instruments across various currencies. In the other, a potential successor, conceived over the past four years by the Federal Reserve Bank of New York and the Fed Board of Governors, as well as a who’s who of Wall Street titans, from JPMorgan Chase & Co and Goldman Sachs Group to BlackRock.
Replacing the London interbank offered rate “would be the most profound development in financial markets” for years to come, said Ward McCarthy, chief financial economist at Jefferies. But “there are more than $300 trillion of financial assets tied to Libor, and if you’re going to transition from that to something else, that’s $300 trillion of potholes that are potentially coming.”
The timing of the ICE Benchmark Administration’s efforts to resurrect Libor could hardly come at a more critical juncture. Its most high-profile challenger, the Secured Overnight Funding Rate, or SOFR, is under mounting scrutiny after the erroneous inclusion of some transactions in settings marred its debut last month. And with futures tied to the benchmark set to start trading on Monday in Chicago, any more damage to its credibility could discourage markets from embracing the upstart reference rate before it gets off the ground.
For decades, Libor provided a reliable way to determine the cost of everything from student loans and mortgages to complex derivatives. It’s calculated from a daily survey of more than 15 large banks that estimate how much it would cost to borrow from each other without putting up collateral. But the trading behind those estimates has dried up, and coupled with the postcrisis discovery of rampant manipulation, regulators felt compelled to take action. Last year, UK officials ostensibly signalled an end to the much-maligned benchmark, saying they’ll stop compelling banks to submit quotes after 2021.
But IBA parent Intercontinental Exchange, which took over administering Libor from the British Bankers Association in 2014, isn’t willing to just let the reference rate die without a fight. After all, more than $150 trillion of financial assets are tied to the dollar-denominated version alone, and ICE makes money from licensing it out. Over the coming weeks, the company has a plan to strengthen Libor, introducing new procedures for how global banks derive and submit the quotes used to generate the benchmark. A shift to a socalled waterfall methodology will see firms begin basing submissions on eligible wholesale, unsecured funding transactions.
If no eligible transactions are available, banks may use quotes from transactions in the secondary market. If there’s still no viable data available, broker quotes and other market observations can be used in the absence of eligible transactions.
“We are hearing significant feedback from banks and their clients that they would like to see a reformed Libor continue beyond 2021, alongside alternative risk free rates,” said Claire Miller, a spokeswoman for ICE.
It may be too little, too late, however. Amid mounting concerns about the reliability and robustness of the benchmark, regulators the world over started searching for replacements. The Federal Reserve in 2014 set up the Alternative Reference Rates Committee (ARRC), bringing together representatives from the private sector, regulators and exchanges to identify an alternative to dollar-denominated Libor. The result was SOFR, a rate that’s designed to be less vulnerable to exploitation that’s is based on repurchase agreements — transactions for overnight loans collateralised by Treasuries.
Last month SOFR made its long awaited debut. It didn’t go well.
Two weeks into its publication, the New York Fed announced that it had unintentionally included certain repo transactions in the source data used to calculate the rate. The bank investigated the readings after it received feedback from market participants about higher-thanexpected transaction volumes underpinning the benchmark.
“The New York Fed was transparent on the issue when it occurred, as well as its implications on the SOFR, which were small,” said Andrew Gray, a spokesman for JPMorgan and co-chair of the ARRC Communication and Outreach Working Group.
“This openness should provide comfort to market participants and other stakeholders as we move forward.”