November 29, 2018
Benchmark Reform
I now turn to the matter of benchmark reform.
I am sure everyone here is familiar with the LIBOR, the short-term unsecured interest rate benchmark. It used to reflect the rate of interest at which money center banks were willing to lend money to each other. Following unfortunate incidents of LIBOR rate rigging, for which the CFTC and others brought numerous enforcement actions that led to subsequent benchmark regulation in Europe, the Financial Conduct Authority (FCA) regulated the ICE Benchmark Administrator. Changes to the methodology and improved controls at contributor banks have reduced the risk of rate manipulation.
Despite these efforts, markets have moved on. Money center banks no longer fund their operations through short-term unsecured loans for 1-month, 3-month, 6-month and so on. Instead, they borrow and lend money overnight on an unsecured basis, enter into overnight secured transactions called repos and borrow money from the capital markets by issuing corporate bonds – 2 year, 5 year tenors.
The fact is that there is no longer a liquid market in unsecured inter-bank term lending underpinning LIBOR. Based on statistics shared by the Federal Reserve Board, there are less than six to seven transactions per day at market rates to support one-and three-month LIBOR across all the submitting banks. Longer maturities have fewer than these. For three-month LIBOR – the standard reference rate in the derivatives markets – on most days, there is less than $ 1 billion of borrowings among the largest banks; on many less days, we see less than $100 million. For one-month LIBOR, the median daily number of actual borrowing transactions which are observable in the marketplace in Q2 2018 was five.
Yet, while LIBOR is no longer based on a thriving market, there is no question that LIBOR remains of systemic importance to global financial markets. Based on estimates published by the US Federal Reserve, there are over $200 trillion worth of financial instruments (equivalent to 10 times US GDP) referencing the US$ LIBOR. While most of this exposure, approximately 95%, is in derivatives (futures and swaps), it also serves as a reference rate for:
- $3.4 trillion in business loans
- $1.8 trillion in floating rate debt
- $1.8 trillion in securitizations, and
- $1.3 trillion in retail mortgages and other consumer and student loans.
LIBOR clearly touches each one of us. From the terms of the most basic home mortgage, to student loan agreements, auto financing contracts, and credit card purchases, LIBOR is pervasive throughout the consumer economy. It is similarly extensive in business and trade finance worldwide.
Regulatory Response
So, on one hand LIBOR is widely used across the financial system and, on the other hand, it is built upon a dwindling market: a heavy edifice on a deteriorating foundation, a tower waiting to fall. The potential for systemic risk posed by this situation is obvious. A regulatory response is clearly appropriate.
Yet, reforming benchmarks is a complex and delicate process, and cannot be done through heavy handed regulatory rulemaking. It was recognized early on by my predecessor, CFTC Chairman Tim Massad, and his contemporaries at the FCA and the Fed that reform should be driven primarily by the private sector with active public sector encouragement and coordination.
In July 2013, the Financial Stability Board (FSB) established an Official Sector Steering Group (OSSG), which includes senior officials from central banks and regulatory agencies, including the CFTC Chair. The OSSG serves to focus the FSB’s work on the interest rate benchmarks that are considered to play the most fundamental role in the global financial system.
The FSB published its recommendations in July 2014 and called for the development of alternative interest rate benchmarks. A determination was made that the banks’ funding behavior has changed fundamentally, and the benchmarks should reflect these changes.
In November 2014, the Alternate Reference Rates Committee, or ARRC, was convened by the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York. The ARRC consists of a group of banks, market participants, industry associations, the CFTC and other US financial regulators.
The ARRC was tasked with two primary goals:
- identify an alternative reference rate to replace LIBOR; and
- develop a market strategy to effect the transition.
After deliberating for over two years, in June 2017, the ARRC selected the Secured Overnight Financing Rate (or SOFR) as the replacement for LIBOR. SOFR’s publication began in April of this year.
SOFR is calculated by the official sector and is based on actual transactions in the repo markets – interestingly, compared to the less than US$1 billion on a good day transacted in the 3-month LIBOR, the SOFR is according to ARRC based on daily repo volumes of over US$700 billion.
Trading in SOFR futures began in the United States in May and the initial trading volumes and liquidity are quite promising. Daily trading volumes for this relatively brand new contract are bigger than the 3-month LIBOR transactions. Firms have started transacting cleared swaps referencing SOFR.
LIBOR’S Days Numbered
The days are numbered for LIBOR. Undoubtedly, there have been huge improvements in the governance process to produce the LIBOR for which the benchmark administrator and the contributing banks deserve much credit. Yet, governance improvements cannot offset the fact that banks have left the marketplace for 3-month unsecured loans. Today, it is only the regulatory authority of the FCA that causes major banks to continue making submissions from which LIBOR is calculated. And that also will not last. Earlier this year, FCA Chief Executive Andrew Bailey said that come 2021, the FCA will no longer be willing to exercise this authority to compel LIBOR submissions.
At some point thereafter, as a critical mass of panel banks quit, the FCA may have to make a determination that the LIBOR is no longer a representative benchmark. If the FCA makes such a determination, supervised firms such as banks, corporates, exchanges, and CCPs operating under UK or EU jurisdiction may no longer be allowed under EU regulation to reference LIBOR for any new derivatives or securities.
Legacy trades can continue to reference LIBOR – what is already being called “Zombie LIBOR” – but imagine the havoc that will be caused in the marketplace if exchanges de-list their contracts, if CCPs cannot accept new swaps for clearing – the whole ecosystem developed to support efficient risk-transfer in our global markets will be in dis-array. Hence, it is critical that legacy positions too move from LIBOR.
I am sure there are some who would rather prefer that we regulators compel banks to continue making submissions. But that would be equivalent to perpetuating a fiction that it is business as usual in the inter-bank term lending markets – that LIBOR is based on hundreds of billions US$ of daily transactions. Unfortunately, we cannot countenance that fiction and the systemic risk it hazards.
Next Steps
Earlier I mentioned the Alternative Reference Rate Committee that has been tasked with leading and directing the transition away from LIBOR to SOFR. It is a private sector led effort. While the CFTC and other US regulators participate as ex-officio members, ARRC’s decisions are made by its private sector members. For example, the decision to select the SOFR as the new reference rate for US Dollar instruments was voted upon by the members of ARRC and supported by the ARRC’s advisory group of end users.
ARRC is now in its 2.0 phase. It is busy with the education and implementation of the transition from LIBOR to SOFR. Its membership has been expanded to a much wider group of market participants. Multiple working groups have been formed to focus on a slew of issues, not all directly related to the derivatives markets.
Let me list a few key initiatives – all happening even as we speak.
ISDA has just closed on a consultation on new fallback language and triggers for a few foreign currencies: GBP, CHF and JPY ISDA will soon be publishing the responses from the first survey, and subsequently be issuing a similar consultation for the US Dollar and for the Euro.
ARRC has formed working groups to examine implications of this transition in other related, but non-derivatives markets – Floating Rate Notes, Business Loans and CLOs, Securitizations, and Mortgages and Consumer Loans. Like ISDA has done for derivatives contracts, consultations have been released for Floating Rate Notes and Syndicated Business Loans. We expect the groups working on Securitizations and Bilateral Loans to publish their consultation in coming weeks.
