photo by Mike Norton
As an overhauled but increasingly irrelevant version of Libor limps toward its inevitable demise, we are getting our first glimpses of its possible replacement. So far, they are encouraging.
As I wrote last summer, the London Interbank Offered Rate, more commonly called Libor, was always flawed because it was based on self-reported estimates instead of real, observable transactions. Libor might have fallen out of favor on its own, but in the wake of the rate-rigging scandal that came to light in 2012, the benchmark’s days were numbered. Self-reported data was, quite demonstrably, dangerously vulnerable to manipulation.
With the announcement last year that the U.K.’s Financial Conduct Authority will no longer ask or demand that banks submit data to the Libor calculation as of 2021, the race to replace Libor was officially on. While Libor may or may not exist after the deadline, it will likely be based on so little information that it will become increasingly useless as a benchmark. Central banks worldwide are committed to finding working alternatives before then.
As of April 3, the U.S. Federal Reserve will begin publishing three reference rates based on the repurchase agreements backed by Treasury securities. The three rates are explicitly designed as Libor alternatives. The Fed’s Alternative Reference Rates Committee identified one of these, the Secured Overnight Financing Rate, as its pick for the best Libor replacement after a series of roundtables in 2016. Now we will get a chance to see SOFR in action.
Unlike Libor, SOFR’s basis is real transactions rather than estimates. The overnight transactions on which the rate is based will come from broker-dealers, money market funds, asset managers, insurers and pension funds. The trading volume that underpins SOFR is substantially larger overall – important, considering that Libor is officially shutting down due to lack of underlying data, rather than fallout from the 2012 scandal. In addition, SOFR will be different from Libor in that the repo rates it is derived from are backed by assets; Libor was supposed to reflect unsecured transactions between banks.
Once the Fed starts publishing SOFR and the other two new repo rates, the next step will be to see if market-makers can successfully create various derivatives based on them. Bloomberg reported that CME Group Inc. plans to launch monthly and quarterly SOFR futures by early May, contingent on regulatory permission. Presumably other products will follow. Eventually, if all goes well, new loans and mortgages will have interest rates pinned to SOFR rather than Libor.
British regulators have also taken steps toward letting Libor go. As of April 23, the Bank of England will take on the calculation and administration of the Sterling Overnight Index Average, or Sonia, and will introduce various reforms to the rate aimed at making it an effective Libor replacement.
How smooth the transition will be is not yet clear. I would expect at least a few short-term bumps in the transition period, mainly here in the United States. Our more litigious society will be more prone to go to court to resolve ambiguities in existing contracts that were predicated on Libor continuing to exist in its previous form and as a primary benchmark. The more the remnant Libor diverges from the new standards, the more likely it is that some party that feels disadvantaged by the difference will try to bolster its position in court.
Regardless, the old Libor contracts will run off eventually, and we should be left with a more transparent and robust standard that reflects the way business is actually being done today. So some good will have come of the Libor scandals after all.