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Bates Research  |  09-05-14

Fed Seeks LIBOR Alternative

This week the Federal Reserve renewed its call for an alternative benchmark to LIBOR. Fed governor Jerome Powell gave a speech Thursday on the need for a new benchmark, and called on market participants to come together in agreeing on one.

On July 22 of this year, the Financial Stability Board released a 700-plus-page report detailing its investigation into the mechanics of replacing LIBOR (and other rates like Euribor, Tibor, etc.) with alternative benchmarks.  In February of 2013, the Finance Ministers and Central Bank Heads of the G20 nations requested an investigation into LIBOR replacement at a scheduled meeting with the FSB. Less than six months later, the group produced a final report, which is a rapid turnaround time for a regulatory entity.

For a detailed look at LIBOR and its uses, please see our white paper on the subject. In brief, LIBOR is a widely used reference rate in the hundred-trillion-dollar swap and derivatives market. Its reach extends into consumer products as well, serving as a reference benchmark for credit cards and mortgages. For a full review of LIBOR's reach, see the table below. It is set by surveying banks about the rates at which they could borrow in different currencies, over different lengths of time.

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The drive to find an alternative rate to LIBOR stems from the discovery that LIBOR had been manipulated to the benefit of LIBOR-setting banks both before and during the Credit Crisis in 2008. Because such a large market segment is tied to a rate that banks have the ability to manipulate, the public outcry for an alternative to LIBOR has been loud. Related fines and penalties amounting to over $6 billion have been assessed globally since LIBOR manipulation was uncovered.

The FSB saw two clear goals in finding a LIBOR alternative: one was to restore investor faith in a commonly used short-term unsecured lending benchmark rate, where confidence in the traditional benchmark had been diminished; the second aspect of the project was to create an interest rate that better reflected risk-free borrowing. While most derivative and interest rate swaps would be better served by using a risk-free underlying reference rate, they have had to rely on LIBOR which can include an element of credit risk (something that became obvious as some banks struggled to find funding during the Crisis). In creating new rates, the FSB is seeking a transparently-set, risk-free benchmark alternative in addition to the LIBOR replacement rate.  They listed the following goals in achieving an "ideal benchmark":

  • Transparent calculation methodology
  • Based on transactions or tradable/realistic quotes
  • Deep, liquid market at all tenors
  • Stringent oversight and governance
  • Stable / low volatility

The group proposed several options for alternative benchmarks, for both a new LIBOR-like rate, and a risk-free benchmark rate. A new measure of unsecured funding, called LIBOR+ would be related to actual transactions (rather than estimated costs, which is the standard now) across bank lending, CDs and commercial paper. For a credit risk-free rate, the group proposed the use of overnight index swap (OIS) rates. Treasury bill rates and repo rates were also considered as short-term risk-free alternatives. A final recommendation was not made regarding the adoption of this proposal, and many potential new rates were dismissed, including FX-implied rates, CDS-implied rates, futures-implied rates, and option-implied rates.

After examining a number of alternatives and time-tables for adopting them, the FSB ultimately concluded that a reasonable goal would be for market participants and administrators to develop an alternative rate and begin transitioning to it by the end of 2015. A risk-free benchmark rate would follow by mid-year 2016.

A great deal of work will need to be done to manage the transition from one set of rates to another, as well as coordination across contracts which involve the older LIBOR rates. While the size of the market is vast, derivative and swap contracts are facilitated by the presence of a uniform benchmark, something which will be untrue as market participants switch to new alternatives. The transition time period presents a great risk to active participants in those markets, something which the FSB has stated it will continue to consider carefully. The FSB envisions a long period of time (five to seven years) in which LIBOR and the new alternatives would exist in parallel, allowing market participants to slowly transition over. The long parallel period would also allow participants to renegotiate existing contracts, create new hedges for legacy positions, incur new operational costs related to the switch over a longer time period, and mitigate liquidity concerns related to a "sudden stop" switchover between rates. We expect more commentary from market participants next week in response to the Fed's statements.