A Federal Reserve-convened committee has narrowed its search for a replacement to Libor, the inter-bank interest rate underpinning trillions of dollars of derivatives and other lending transactions throughout the financial system that has been rocked by fraud scandals in recent years.
A report released Friday by the Alternative Reference Rates Committee, a group that includes representatives from the private sector and regulators, proposed two possible replacements for the London Inter-Bank Offered Rate. The U.S. central bank's benchmark federal funds rate was considered, but ultimately discarded as an option because choosing it “could be seen as a constraint on changing the monetary policy framework” in the future, according to the report.
Jump-starting either of the proposed alternatives would require moving derivatives contracts that currently reference the fed funds rate to the new rate, which would further lessen the market's reliance on the benchmark that serves as the target of U.S. monetary policy.
“The conception of this thing was clear, and is, I think, pretty broadly agreed, but execution is challenging,” Fed Governor Jerome Powell said in an interview. The report “lays out a path going forward. We can make this path work.”
Libor is used as a reference in the pricing of more than $160 trillion of derivatives contracts and trillions of dollars more of business loans and mortgages, according to the ARRC report. Regulators realized the need to replace it after a series of fraud scandals revealed how easy the rate was for traders to manipulate.
Two Options
A new metric the Federal Reserve Bank of New York began publishing in March, called the overnight bank funding rate, is the first option. That rate adds roughly $250 billion of daily eurodollar transactions — which are largely banks borrowing from non-bank financial institutions, like money-market mutual funds — to the roughly $70 billion of daily fed funds transactions that go into the calculation of the effective fed funds rate.
The second option under consideration is a rate based on transactions in the market for repurchase agreements collateralized by Treasury securities. The viability of this alternative is not as clear, as the Fed has not yet begun producing such a rate, although it's considering doing so, according to the minutes of the Federal Open Market Committee's December meeting.
Getting market participants to transition trillions of dollars worth of contracts to a new reference rate is no easy task. The ARRC report laid out a strategy, but cautioned that more needs to be done in consulting with users of Libor and working through outstanding regulatory issues.
The report called for comments on the proposal to be submitted to the committee by July 15, and said the group will host a roundtable at the New York Fed on June 21 to further discussions of the process.
U.S. Treasury Acting Assistant Secretary for Financial Markets Daleep Singh said in a statement that the “Treasury looks forward to engaging with market participants to discuss the choice of an alternative rate and an appropriate transition strategy.”
Bloomberg News
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