Duffie: regulators may push swaps market off Libor

Even reformed Libor no longer a viable reference rate, says FSB adviser

Darrell Duffie - Stanford University
Darrell Duffie: overnight lending rates are most suitable option for benchmarks

Regulators may need to act if banks are to shift liquidity in the swaps market away from Libor towards a reference rate based on overnight lending rates, according to a senior adviser to the Financial Stability Board (FSB) on benchmark reform. Regulators insist a change is needed, but rules requiring it are not on the cards – leaving open the question of how any switch would be engineered.

Speaking on January 25 at the Prime Finance conference in The Hague, Darrell Duffie, a professor of finance at Stanford University who chaired the market participants' group created by the FSB as part of its benchmark reform project, suggested regulators will need to "encourage" banks to begin quoting two-way prices in swaps referencing overnight or repo rates in an effort to bolster liquidity beyond the current, comparatively thin levels.

"There isn't that much liquidity in overnight rates compared to three-month or six-month Libor, so if I say 'why don't you start trading swaps on overnight rates', you might say 'well, the transaction cost would be unattractive because most of the liquidity is in three-month Libor'. I would have a hard time to convince you. Who we must convince are the major dealers who offer you these swaps, and encourage and require customers to move into new products, which they don't want to do unless regulators encourage that process as well," said Duffie.

His comments echo those of Jerome Powell, a member of the Federal Reserve Board and co-chair of the Official Sector Steering Group – a group of 21 high-ranking officials from 11 countries who prepared a July 2014 report for the FSB on benchmark reform – who told Risk.net when the steering group presented its report that the central bank is planning to "help" banks understand that the current market status quo is not good for them.

Several central bank-sponsored working groups spanning the five major currencies in the rates market are set to report later this year on proposals to meet post-Libor reform goals set out by the FSB to revise existing benchmarks based on unsecured interbank lending rates, and to come up with alternative risk-free rates.

Working groups in Switzerland, the UK, and US are currently considering the suitability of overnight rates as an alternative benchmark for the rates markets. Revised iterations of existing indexes, such as Sonia – the sterling overnight index average – or secured overnight lending benchmarks, such as repo rates or general collateral rates, or a blended fixing based on a number of rates are all under consideration.

Duffie argued benchmarks tied to overnight lending rates – whether secured or unsecured – represent the most robust option, because they could be used to reliably calculate quarterly and semiannual coupon payments and replace the use of three-month and six-month Libor as the swap market's de facto reference rates.

"There have been proposed improvements of [Libor] fixings, but this market is simply not big enough to handle the elephant of interest rate derivatives transactions," he said. "If we get [rates trading] to move on to an overnight interest rate... you are moving the elephant essentially off this plank on to a major concrete bridge. It will be much safer. The risk of the elephant crashing through will be much reduced," he said.

Reforms in train for existing unsecured lending rates such as Libor and Euribor will see the fixings shift to transaction-based fixings and away from quoted rates, to help safeguard against manipulation.

However, that won't be enough, Duffie argued. Instead, interest rate swap markets should be moved on to benchmarks based on overnight rates, which are still less susceptible to manipulation since they are revised daily.

"The main problem is that some market participants would rather not have a daily flowing rate; they would rather have a coupon every three to six months. In that case, the simple solution is to compound up the daily rate over the three-month period; then you have your three-month coupon rate for a floating-rate note or interest rate derivatives over three months," said Duffie.

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