Proposed Alternative to Libor Faces Tough Road Ahead

WASHINGTON — A committee convened by the Federal Reserve to examine potential replacements for widely used interbank offered rate benchmarks has published its interim conclusions, identifying two potential alternatives.

But major challenges stand in the way of broad international adoption of any new benchmark rate, the report said, including the broad array of loans, derivatives and bonds that reference the old rate all over the world.

Sandie O'Connor, chair of the Alternative Reference Rates Committee and chief regulatory affairs officer at JPMorgan Chase, said the panel's report is an opening salvo in continuing international efforts to replace the discredited and illiquid London interbank offered rate, or Libor, with alternatives that represent real market trends and serve the needs of financial service customers.

"It's essential that we find alternative rates and alternative benchmarks that can be more squarely based on transactions and more durable over time," O'Connor said. "Our goal is not to necessarily replicate [Libor], but rather create an alternative benchmark that is appropriate and fits the purpose of the end user."

The Federal Reserve in 2014 convened the ARRC in response to concerns from both the international Financial Stability Board and the U.S. Financial Stability Oversight Council that Libor and other interbank benchmark rates had ceased to be effective as a stable, liquid and secular interest rate upon which derivatives and other various financial transactions can be based.

Interbank lending effectively ceased after the financial crisis, thus debasing the transactions upon which Libor was founded. The benchmark's reputation was further tarnished when revelations of widespread manipulation of the rate by banks came to light in 2012. Those banks paid billions in fines related to the scandal.

The ARRC was composed of representatives of the largest global interest rate derivatives dealers and central counterparties, as well as representatives of the Treasury and Fed as ex officio members.

Fed Gov. Jerome Powell said the Fed and other regulators play a facilitating role in establishing an alternative rate, but the market itself will ultimately have to decide what to reference in its transactions. The committee, which represents primarily derivatives brokers, will now engage with derivatives buyers — primarily hedge funds and asset managers — to achieve the universal goal of transitioning away from the tainted and illiquid interbank rates.

"I think everyone agrees and understands that the plan to move a lot of the trading to a new rate is a much better equilibrium for the whole system," Powell said. "No one can just order that done. We need the expertise of these firms, they are committed to achieving this goal, so we're well aligned in this. We perform a coordinating role."

In the ARRC's interim report issued Friday, the committee winnowed the potential replacements to one secured and one unsecured rate: the overnight bank funding rate, or OBFR, and an overnight Treasury general collateral repo rate. While both rates represent deep underlying markets with high transaction volume — features deemed necessary for a replacement to Libor — a transition to either benchmark represents a substantial challenge, the report said.

"This plan envisions gradually moving price alignment interest and also eventually discounting from the effective federal funds rate to the new rate chosen by the ARRC," the report said. "If adopted, a paced transition would represent a first step in creating a liquid market for the alternative rate, but further work would be required ... for a full transition strategy that would move a more significant portion of the derivatives markets away from Libor to the new rate."

The committee had originally considered various other rates, including the federal funds rate, the interest on excess reserve rate, and Treasury yield rates. The rates committee settled on the OBFR and overnight Treasury repo because they represent deep and liquid markets — the overnight bank funding rate represents an average of $300 billion in transactions per day — and because unlike other benchmarks like the federal funds rate or interest on excess reserves, they float independently of monetary policy considerations. The committee will make a final determination on which of the two benchmarks it prefers as an alternative to Libor, but did not specify when that final decision might be made.

The ARRC said that while uniformity among dealers and clearing counterparties is important, successful implementation will ultimately depend on widespread adoption by end users — that is, firms buying interest rate derivatives to hedge a position. To facilitate this, the member banks and market participants must engage in "voluntary trading … sufficient to achieve a critical mass of liquidity in futures contracts and/or derivative contracts that reference the new rate."

That transaction history will hopefully jump-start more widespread adoption of the new rate in swaps and futures contracts by central counterparties, dealers and end users, the report said. But even if that occurs, a "robust market structures" for hedging basis risk — that is, the risk that the new hedging strategy will not be compatible with the old one — needs to be considered to ease the transition, the report said. A streamlined process for central counterparties to receive regulatory approval for products referencing the new rate will also be necessary, the report said — and that is just for the initial transition.

"A paced transition would represent a first step in creating a liquid market for the alternative rate, but further work would be required — following consultation and close involvement with end users — in planning for a full transition strategy that would move a more significant portion of the derivatives markets away from Libor to the new rate," the report said.