US Fed’s Alternative Reference Rate - Unearthing the LIBOR Replacement

Lately, If you are anyway related to the financial industry, chances are you would have heard about the buzz word of Financial Regulatory Reforms. A clear consequence of scandalous activity that dominated headlines for the better part of this decade - with the hashtag of #LIBOR. A lot has been done and a lot more has been put in motion by regulatory authorities around the world to prevent the repeat of such a crisis and to restore the faith of investors in these benchmarks. 

First wave of such reforms involved an overhaul of the existing processes, administrators and contributory practices prevalent amongst the various stakeholders. The renewed focus on the necessity of determining benchmarks based on underlying transactions seem to be the driving force behind such reform activities. This is evident in the transaction-based Waterfall Methodology being introduced in various key benchmarks such as LIBOR, EURIBOR, SONIA and the like.

The second wave, however, is independent of the existing boundaries set by these long standing benchmarks. It goes beyond and aims to find alternatives to the existing benchmarks - a robust, market-driven and structurally-stable benchmark rates which can be depended upon. The regulators of major financial markets have already begun this process of finding alternative rates from Bank of England’s Sterling Risk-Free Reference rates, Japan’s Study Group on Risk Free Reference Rates, Switzerland’s National Working Group to Federal Reserve’s Alternative Reference Rate Committee (ARRC).

For this discussion, the latter is of most interest and necessitates further understanding of the activities of the major financial market. 

The Impetus

Initiated as a response to the recommendations of the Financial Stability Oversight Council (FSOC) and the Financial Stability Board (FSB), the ARRC was convened by the Federal Reserve Board and the Federal Reserve Bank of New York with four clear objectives:

•  Identify best practices for alternative reference rates
•  Identify best practices for contract robustness
• Develop an adoption plan
• Create an implementation plan with metrics of success and a timeline 

The fundamental premise for ARRC is borne out of FSB and FSOC’s findings - the decline in wholesale unsecured short-term funding by banks. Given that the USD LIBOR is used a benchmark in large volume of transactions ($160 trillion outstanding notional) on a variety of financial products and contracts, it’s availability and robustness can be directly correlated to the institutional and market stability in the United States.

The Criteria

The task at hand is not a simple one and the mandate for the group is clear - to find a potential rate which is risk-free or nearly risk-free and which does not constrain future monetary policy or congressionally-mandated policy goals and those which should adhere to the IOSCO principles for financial benchmarks. 

Six alternatives were evaluated on the following criteria:

•  Benchmark Quality - The degree to which the benchmark design ensured the integrity and continuity of the rate
• Methodological Quality - The degree to which the benchmark construction could satisfy the IOSCO Principles for soundness and robustness.
• Accountability - Evidence of a process that ensures compliance with the IOSCO Principles
• Governance - Evidence of governance structures that promote the integrity of the benchmark
• Ease of Implementation - Assessed ease of transitioning to the rate

Two of the six rates were further selected to be the potential replacement to LIBOR:

• Overnight Unsecured Lending Rate
• Secured (GC Repo) Lending Rate

The Rates

Overnight Unsecured Lending Rate, currently, is served in two flavours by the Federal Reserve -The Effective Federal Funds Rate (EFFR) and the Overnight Bank Funding Rate (OBFR). The former is a volume-weighted average median of overnight transactions in the fed funds market while the latter is a volume-wighted average median of both overnight fed funds and Eurodollar transactions. Collected from a set of 150 banks in the United States, both these rates are based on daily transactions and are thus potential candidates for the replacement rate. However, since OBFR has a larger size of market ($300bn vs $70bn) and diversity of counterparties coupled with the high potential for robustness, it is chosen as the overnight unsecured lending rate for for further consideration.

The other potential alternative for contention is based on Overnight Secured Treasury GC Repo Lending. This market is high-volume transaction driven, and witnesses a wide range of market participants and is perceived as robust. Even though the ARRC has identified this market as the potential alternative, it has not zeroed-in on the actual rate to be used. There are multiple options which are privately produced and currently active. However the ARRC’s preferences lie in public sector produced rates. The work regarding the rate based on Overnight Secured GC report lending market is in the works.

Bracing for the Future

The transition to any rate selected requires careful and deliberate process so as to not disrupt market stability. The proposed method of paced transition is based on achieving this objective. While the efforts of regulators across the geographies are being consolidated towards the same goal, it is essential to understand the far reaching consequences of any reform activity undertaken. 

Firstly there is the debate of market acceptability of the new referencing rates. Even though the idea of market or user-driven adoption plans by regulators is evident, it is unclear as to whether this would actually materialise to the fullest extent. This idea is deep rooted in the fact that the benchmark rates envisaged to be replaced are dominant in the world financial markets and the idea of replacing them will present a host of challenges apart from market acceptability. Even the Wheatley report on the backdrop of fresh allegations of benchmark-rigging way back in 2008 indicated to reforms instead of replacements. While we may have long way from that crisis period, the importance of these benchmarks (IBOR+) still remains in the financial markets.

A crucial success factor in this activity is also the availability of market liquidity for the new replacement rates. This is a classic circular challenge where the success of new rate is dependent on the adoption by the market and market in turn will adopt if the new rate is successful representation of the long standing benchmark it intends to replace.

Secondly, the transition to a new rate would mean a plethora of strategic, business and technological changes for the stakeholders of these benchmarks - administrators, contributing financial institutions and the end-users. With multiple regulations and cross-boundary regulators vying for same set of resources through compliance, it becomes a challenge for the banks and financial institutions to cope up with the additional burden. More so in the light of heavy regulatory costs incurred by these institutions in the post-crisis period in the form of fines, settlements, regulatory projects and compliance activities.

However, there is no denying that the activities being undertaken are crucial for long-term financial stability across markets. It may be a challenging but necessary activity. All the stakeholders - Regulators, Banks and Financial Institutions (in the capacity of contributors and consumers), Benchmark Administrators and the consumers need to come together to strategise and implement these changes in a manner that is least disruptive of the market and ensure a smooth transition to the new era of robust, reliable and representative benchmarks.

Disclaimer: The views and opinions expressed herein are those of the author and do not represent the views and opinions of the Associates in Capital Markets (ACAPM) or any of its subsidiaries or affiliates or clients.