Darrell Duffie is the Dean Witter distinguished professor of finance at Stanford University’s Graduate School of Business, and professor by courtesy in the university’s economics department. He has recently been an adviser on financial markets to a range of bodies, including the Financial Stability Board and several Federal Reserve banks.
Libor is a sick man. At some point, it may be necessary to place him on life support – but he can’t be allowed to expire any time soon. Tens of trillions of dollars of debt and hundreds of trillions of dollars of derivatives, with maturities ranging up to 30 years or more, have interest payments that must be calculated from daily announcements of Libor and its close cousin, Euribor.
Recent efforts to shore up the robustness of these interbank offered rates (Ibors), although beneficial, are not nearly enough to fix the problem. Big banks no longer do enough of the unsecured borrowing transactions whose rates are used to calculate the Ibors. At the end of 2016, the administrator of Libor reported that actual transactions make up less than 30% of the data used to produce three-month and six-month US dollar Libors, the main benchmarks for swaps, bonds and loan contracts. Almost all of the remaining data used to fix these Libors are “expert judgements”. In setting three-month Swiss franc and yen Libors, actual transactions now comprise under 5% of the data.
A globally recognised International Organization of Securities Commissions principle is that benchmarks should be based on transactions data or executable market quotes. Adherence to this principle reduces the vulnerability of benchmarks to manipulation. Even without manipulation, benchmarks are not so useful for hedging and other applications if their fixings can wander away from actual fair-market pricing.
Because the financial system depends so heavily on weakly founded Ibors, regulators and market participants have been working on a plan to shift markets toward other benchmarks. The top candidates are overnight interest rates.
In the UK and US, the key upcoming decision is whether to champion an overnight benchmark rate based on unsecured borrowing transactions, or one based on repos collateralised by government securities.
In the UK, the leading unsecured overnight benchmark rate, Sonia, is fixed by the Bank of England. The leading secured rate, the Sterling Repo Index Rate, is administered by broker Nex. We still don’t know which of these will be put forward as the preferred alternative to Libor.
In the US, the Alternative Reference Rate Committee (ARRC) is also yet to show a preference between an unsecured and secured (repo) overnight benchmark. At this point, the favoured unsecured rate is the Overnight Bank Funding Rate (OBFR), calculated by the Fed. The ARRC is still uncertain which segments of the repo market to include in a new secured overnight benchmark.
The big regulatory move towards collateralised swaps has made it more natural for derivatives intermediaries to use secured rates to discount and hedge their cash flows
I suspect that the main new US overnight interest-rate benchmark should be one of the broader-based repo rates proposed by the New York Fed. Despite important changes in the structure of repo markets reported by the Committee on the Global Financial System, I believe that stressed market conditions or changes in regulation or practice would likely cause even greater disruption to unsecured rates and trade volumes. For example, the regulatory reform of money market mutual funds has had a significant impact on the mix of transactions collected to produce OBFR.
Moreover, the big regulatory move towards collateralised swaps has made it more natural for derivatives intermediaries to use secured rates to discount and hedge their cash flows.
Meanwhile, the number of banks participating in the Euribor fixing process is dwindling, probably over costs and legal exposures. For now, eurozone authorities have shown a preference to stick with Euribor, but they are also developing an overnight euro repo benchmark. Switzerland is transitioning to a secured overnight rate, Saron. Japanese authorities have selected an unsecured overnight rate, Tonar.
Once an overnight rate is chosen, many investors will still prefer to make their floating interest payments at monthly, quarterly, or semi-annual frequencies. For this purpose, overnight benchmark rates can be compounded day by day within each interest period to determine the end-of-period payments. This is already done for overnight index swaps, which have only one interest period, and the practice could easily become a widely accepted convention.
Even after a single overnight benchmark has been put forward, it would be useful for the market to have access to both secured and unsecured overnight benchmarks. When trusted, benchmarks support more transparent and efficient markets. Access to both types of benchmark also allows greater financial innovation.
The biggest remaining challenge will be to get market participants to reduce their reliance on Ibors and to increasingly reference the chosen overnight benchmarks. A transition from liquidly traded Ibor swaps, for example, to swaps based on less-frequently referenced overnight rates, will require some guidance from regulators and dealers. However, the recent surge of volumes in overnight index swaps relative to Libor swaps show that this transition is feasible.
Darrell Duffie chaired the Financial Stability Board’s Market Participants Group for Reference Rate Reform. He is grateful for conversations with the members of the Market Participants Group and with Piotr Dworczak, Jeremy Stein, Haoxiang Zhu, and many unnamed regulators and market participants.