Volatility threatens Libor replacement

On 16 September, the US treasury repo market was hit by large fluctuations in short-term interest rates

The UK’s regulatory authorities have decided not to require banks to make submissions to the London interbank offered rate (Libor) after the end of 2021. Both the UK and the US regulators have selected alternatives to Libor; the sterling overnight index average (Sonia) for the Bank of England and the secured overnight financing rate for the US.

Neither rate has Libor’s qualities: a forward-looking yield curve with a built in credit risk premium, reflecting the perceived credit risk of the sample of banks contributing to the rate. Both the UK and the US have endeavoured to turn their overnight rates into forward-looking rates.

Compounded Sonia is supposed to be a solution, but the loan market still requires details of the amount due ahead of the payment date. In the US, Tom Wipf, head of the Alternative Reference Rate Committee, composed of market practitioners, confessed that ‘if anyone can figure out a credit spread, we haven’t and we are a big group of people, 800 in the market.’ But UK and US regulators are still pushing the transfer from Libor even for trillions of dollars’ worth of legacy contracts. The ‘risk-free’ benchmark may not be so ‘risk-free’ after all.

On 16 September, the US treasury repurchase agreements (repo) market was hit by large fluctuations in short-term interest rates, taking everyone by surprise. Quarterly tax payments for corporations and some individuals were due at the time. Taxpayers, as usual, took $100bn out of their bank and money market accounts to pay before the deadline. The Treasury increased its long-term debt by $54bn by paying off maturing securities and issuing more long-term debt. Buyers then withdrew money from bank and money market accounts to pay for the new investments, thus reducing liquidity in the financial system.

Even allowing for these events, the ‘size of the reaction in repo rates, the spill over to the federal funds market, and the emergence of strains in the market functioning were outside recent experience’, according to John C Williams, CEO of the New York Fed. Overnight repo interest rates reached 10% with some contracts settling at 9%. The effective funds rate also rose to 2.30%, above the 2.25% upper limit of the Fed’s target rate. The intraday rate unexpectedly rose almost 2%. Various explanations, such as changes in market structure or the Fed’s monetary policy, have been offered, but none have held sway.

To calm the repo market, the Fed lent $75bn in overnight repos, for which borrowers had to provide Treasury securities as collateral and pay back the money with interest the following day. These loans were only available to the 24 primary dealers and certain banks. This support was increased to $120bn per day on 23 October 2019. It was due to be reduced to $100bn from February 23 2020 with the likelihood that it will continue until mid-2020. The aim is to keep the Fed funds rate stable and limit money-market volatility.

The International Organization of Securities Commissions states that the data used to construct a benchmark should be ‘based on prices, rates, indices or values that have been formed by the competitive forces of supply and demand (i.e. in an active market) and be anchored in observable transactions entered into at arm’s length between buyers and sellers in the market for the interest the benchmark measures.’ The IOSCO principles do not envisage the US situation, but with a Fed interventions of over $500bn, the repo market is not just a matter of competitive supply and demand, but one in which the aim appears to be to keep the SOFR rate in line with the target Fed funds rate.

Maybe the time has come to follow the European Union, which recognises the importance of the euro interbank offered rate for loans. The EU and the European Money Markets Institute has no plans to terminate EURIBOR if it remains compliant with the benchmark administration regulations.

Oonagh McDonald is a former board member of the Financial Services Authority and author of Holding Bankers to Account.

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