A collection of British five pound banknotes sit in this arranged photograph in London, U.K. (Photographer: Miles Willis/Bloomberg)

Libor Refuses to Die, Setting Up $370 Trillion Benchmark Battle

(Bloomberg) -- A struggle that will dictate the future of financial markets is brewing. Long beleaguered Libor is fighting to preserve its status as the premier global benchmark for dollar-based assets just as questions pile up over the credibility of its presumptive heir.

It’s a clash with few equals in financial history. In one corner, the much maligned set of London-based rates that, even after being tainted by rigging scandals, still underpin more than $370 trillion of instruments across various currencies. In the other, a potential successor, conceived over the past four years by the Federal Reserve Bank of New York and the Fed Board of Governors, as well as a who’s who of Wall Street titans, from JPMorgan Chase & Co. and Goldman Sachs Group Inc. to BlackRock Inc.

Replacing the London interbank offered rate “would be the most profound development in financial markets” for years to come, said Ward McCarthy, chief financial economist at Jefferies LLC. But “there are more than $300 trillion of financial assets tied to Libor, and if you’re going to transition from that to something else, that’s $300 trillion of potholes that are potentially coming.”

The timing of the ICE Benchmark Administration’s efforts to resurrect Libor could hardly come at a more critical juncture. Its most high-profile challenger, the Secured Overnight Funding Rate, or SOFR, is under mounting scrutiny after the erroneous inclusion of some transactions in settings marred its debut last month. And with trading in futures tied to the benchmark having debuted Monday, any more damage to its credibility could discourage markets from embracing the upstart reference rate before it gets off the ground.

Libor Refuses to Die, Setting Up $370 Trillion Benchmark Battle

For decades, Libor provided a reliable way to determine the cost of everything from student loans and mortgages to complex derivatives. It’s calculated from a daily survey of more than 15 large banks that estimate how much it would cost to borrow from each other without putting up collateral. But the trading behind those estimates has dried up, and coupled with the post-crisis discovery of rampant manipulation, regulators felt compelled to take action. Last year, U.K. officials ostensibly signaled an end to the much maligned benchmark, saying they’ll stop compelling banks to submit quotes after 2021.

But IBA parent Intercontinental Exchange Inc., which took over administering Libor from the British Bankers Association in 2014, isn’t willing to just let the reference rate die without a fight. After all, more than $150 trillion of financial assets are tied to the dollar-denominated version alone, and ICE makes money from licensing it out. Over the coming weeks, the company has a plan to strengthen Libor, introducing new procedures for how global banks derive and submit the quotes used to generate the benchmark.

A shift to a so-called waterfall methodology will see firms begin basing submissions on eligible wholesale, unsecured funding transactions. If no eligible transactions are available, banks may use quotes from transactions in the secondary market. If there’s still no viable data available, broker quotes and other market observations can be used in the absence of eligible transactions.

“We are hearing significant feedback from banks and their clients that they would like to see a reformed Libor continue beyond 2021, alongside alternative risk free rates,” said Claire Miller, a spokeswoman for ICE.

Libor Refuses to Die, Setting Up $370 Trillion Benchmark Battle

It may be too little, too late, however. Amid mounting concerns about the reliability and robustness of the benchmark, regulators the world over started searching for replacements. The Federal Reserve in 2014 set up the Alternative Reference Rates Committee, or ARRC, bringing together representatives from the private sector, regulators and exchanges to identify an alternative to dollar-denominated Libor.

The result was SOFR, a rate that’s designed to be less vulnerable to exploitation and is based on repurchase agreements -- transactions for overnight loans collateralized by Treasuries.

Libor versus SOFR: the key differences

  • Whereas Libor relied on the expectations of bankers, SOFR is based on real repurchase agreement transactions compiled by the New York Fed
  • SOFR is a secured rate, since the repo trades it’s derived from are collateralized, while Libor is unsecured
  • SOFR is an overnight rate, based specifically on overnight loans. Libor, by contrast, covers maturities ranging from one day to one year
  • The volume of trading underpinning SOFR is roughly $700-$800 billion daily, versus an estimated $500 million for three-month Libor

Last month SOFR made its long awaited debut. It didn’t go well.

Two weeks into its publication, the New York Fed announced that it had unintentionally included certain repo transactions in the source data used to calculate the rate. The bank investigated the readings after it received feedback from market participants about higher-than-expected transaction volumes underpinning the benchmark.

“The New York Fed was transparent on the issue when it occurred, as well as its implications on the SOFR, which were small,” said Andrew Gray, a spokesman for JPMorgan and co-chair of the ARRC Communication and Outreach Working Group. “This openness should provide comfort to market participants and other stakeholders as we move forward.”

Libor Refuses to Die, Setting Up $370 Trillion Benchmark Battle

But the mistake also underscored a laundry list of concerns traders and strategists have raised since launch. Chief among them, the fact that SOFR is based on secured transactions, rather than unsecured, as Libor is. That decision strips out the credit element that served an important market function in hedging and securities pricing, according to McCarthy, making SOFR’s viability as a Libor replacement tenuous from the start.

Beyond that, SOFR appears significantly more volatile than Libor, and more susceptible to price swings tied to Treasury bill issuance as well as month- and quarter-end supply variations. Questions persist over why SOFR continues to print at or above overnight Libor and the Federal Reserve’s interest on excess reserves rate for banks, while some are challenging just how reliable the new reference rate will be in times extreme financial stress.

Last, but not least, is the fact SOFR is an overnight rate that lacks any sort of term structure. Monday’s introduction of monthly and quarterly futures is intended to be the first step in addressing this critical shortcoming. If all goes according to plan, there will be enough market activity to facilitate the creation of additional tenors.

“Libor will go away and we need a rate that hundreds of trillions of dollars of contracts can migrate to, New York Fed President William Dudley said Friday at an event at Bloomberg headquarters in New York. “Eventually we’ll get a term curve for SOFR, and then the heavy lifting will occur, which is when we move the existing set of contracts that we have today that reference Libor onto SOFR.”

No one’s expecting SOFR volumes to challenge Libor-based eurodollar futures -- which see about $100 billion to $300 billion of turnover a day -- or even the lesser traded fed funds complex, anytime soon. For now, trustworthy data is what’s needed most, investors say. Transitioning away from Libor will likely be an arduous process for most, even under the best of circumstances, and another stumble could significantly hamper its reception.

That has many market participants predicting something akin to a draw in the battle for global benchmark supremacy.

“They’re two separate highways, but both need to exist,” said John Coleman, managing director of the fixed-income group at R.J. O’Brien & Associates, a futures brokerage in Chicago. “There has to be a channel for unsecured lending. Libor must continue. Whether it continues as the A-list rate remains to be seen.”

‘Other Options’

Ultimately, the market will determine Libor’s successor. Coleman says a better replacement for the unsecured benchmark would be the average rate from the Federal Home Loan Bank system, where thousands of lenders already transact every day. Another option is Ameribor, the brainchild of Richard Sandor, an economist who pioneered interest-rate futures and derivatives at the Chicago Board of Trade. Ameribor is a new interbank rate that reflects borrowing costs based on the transactions of members of the American Financial Exchange.

Trading volume in Libor-based swaps is already being challenged by activity in contracts based on the overnight fed funds rate, as some companies start using the derivatives for financing activities in preparation for the demise of the ubiquitous reference rate.

In the meantime, the ARRC will keep working with market participants getting ready for life after Libor. ICE will continue rebuilding the fraught reference rate to keep it alive after 2021. And investors will continue searching for the benchmark that works best for them.

“For now Libor is still preferred as it’s the most liquid and deepest set of contracts that we have,” said Chris Sullivan, chief investment officer at the United Nations Federal Credit Union, which manages over $2 billion in U.S. fixed-income assets. “But we will be watching SOFR pretty closely just to see how its received, managed and traded. We want to see how it’s received and what the major risks are with it.”

©2018 Bloomberg L.P.