The aftermath of the financial crisis uncovered many nefarious financial market activities. Among them was the tradition, among banks, of manipulating the LIBOR rate. A major US antitrust class action ensued and countless other complaints materialized.
That the LIBOR fixings were manipulated was an open secret among financial market participants stretching back to the late 1980s, but in the wake of fines and civil settlements, regulators have decided to disband LIBOR as a benchmark for determining the reset rate for loans, swaps, and other derivative products.
It has been decreed that LIBOR will cease to be calculated from January 3, 2022. This presents two principal issues, firstly the choice of a replacement rate and secondly the need to renegotiate existing LIBOR-linked contracts that mature after January 3, 2022. While in the Eurozone an overnight unsecured rate (Ester) is to be adopted, the Federal Reserve (Fed) has chosen to return to collateral-backed funding. To understand the reason for their adoption of SOFR — Secured Overnight Funding Rate — in lieu of LIBOR one needs to understand the problem with LIBOR.
The regulators’ main issue with LIBOR is that it is not a market-determined rate. Instead, the rate is established by taking quotations from a panel of banks, by which means a trimmed average rate is determined. Moving to an actual traded rate, such as SOFR, should ensure that those rates are tradable rather than indicative (and therefore open to manipulation). There are, however, two issues, and numerous outcomes, that make SOFR a problematic substitute.
First, SOFR is a secured rate, and collateral, such as US T-Bills, must be pledged as security. Its rate, therefore, is, in part, determined by the availability of that collateral. LIBOR is, as its name implies, the London Interbank Offered Rate. This rate is unsecured and reflects the general creditworthiness of the interbank market.
The second issue is more nuanced. LIBOR is a forward-looking rate. While there is a daily overnight LIBOR fix, it is the one-month, three-month, six-month, and one-year fixings that are of greater importance for the majority of loan instruments. Interest Rate Swaps, for example, used to be priced in relation to the six-month LIBOR fixing, although, since the financial crisis, an increasing number of contracts reference the OIS — Overnight Index Swap — rate, in part a reflection of the distrust with which banks regard one another’s credit. By virtue of their longer maturity, LIBOR rates reflect expectations of the direction of interest rates while overnight rates do not.
The effects of moving to SOFR are that the daily setting of the interest rate may be inherently more volatile; that the rate will not reflect changes in the credit quality of the banking system; and, finally, that the Fed must become even more pivotal in order to manage overnight rates on a daily basis.
In mid-September the ability of the Fed to control SOFR was severely tested. The table below shows the rate for the Effective Federal Funds Rate — EFFR, SOFR, one-month LIBOR, and three-month LIBOR, together with the spread differentials. This is a snapshot over just three days, September 13, 16, and 17.
The chart below depicts the final three columns. It highlights the dramatic nature of the move in the SOFR rate relative to both EFFR and LIBOR that occurred, especially on September 16.
The sharp rise in SOFR briefly dragged the EFFR through the top of the Fed’s target rate band, but it had no noticeable impact on the relationship between one-month and three-month LIBOR, which sailed calmly on, unruffled by the fracas.
The Fed explained the reasons behind this sudden squeeze in overnight SOFR: quarterly tax payments amounting to $100 billion and Treasury issuance of $54 billion. These were hardly unexpected drains of liquidity.
Out of the Frying Pan
Until SOFR was catapulted into the limelight as the heir to LIBOR, it had received little attention from the outside world. Now, as SOFR becomes a key determinant of the next generation of financial transactions, its stability needs to be underpinned. Where the interbank market once manipulated LIBOR for nefarious purposes, the Fed must assume a strikingly similar mantle, simply to ensure the smooth operation of the financial system.
According to the BIS Quarterly Review, March 2019, $400 trillion of financial contracts referenced a LIBOR rate as of June 2018 — about half of which are denominated in US$. They favor moving to risk-free-rates (RFRs) but acknowledge the difficulty in making these markets liquid enough to support the needs of the international banking system. The BIS accepts that banks must manage asset-liability risk. They are therefore prepared to sanction the use of credit-sensitive benchmarks to provide a close match to marginal funding costs as an acceptable interim solution.
The BIS defines the properties of an ideal benchmark thus:
(i) provide a robust and accurate representation of interest rates in core money markets that is not susceptible to manipulation. Benchmarks derived from actual transactions in active and liquid markets, and subject to best-practice governance and oversight, represent arguably the best candidates in terms of this criterion; (ii) offer a reference rate for financial contracts that extend beyond the money market. Such a reference rate should be usable for discounting and for pricing cash instruments and interest rate derivatives. For example, overnight index swap (OIS) contracts of different maturities should reference this rate without difficulty, providing an OIS curve for pricing contracts at longer tenors; and (iii) serve as a benchmark for term lending and funding. Given that financial intermediaries are both lenders and borrowers, they require a lending benchmark that behaves not too differently from the rates at which they raise funding.
These are laudable objectives, but with the demise of LIBOR there is no suite of liquid benchmarks to fill the void. In the near term, money markets are showing signs of strain. With interest rates in developed countries close to or below zero, transaction activity has diminished. This has been exacerbated in the US by the Fed’s decision to pay interest on bank balances held at the Federal Reserve. Term repos (those that are longer than overnight) remain illiquid. Beyond overnight funding, a liquid, credit-sensitive, alternative to LIBOR does not yet exist. Nonetheless, as the use of overnight funding rates becomes ubiquitous, liquidity should increase. Additional central bank liquidity will help to support the transition.
The International Organization of Securities Commissions (IOSCO) framework proposal, which was published in 2013, calls for the eventual inclusion of additional eligible securities in secured overnight funding markets, including bank repos. It also advocates the introduction of reference data derived from non-bank transactions, such as money-market funds. In the fullness of time a replacement for LIBOR will develop. This evolution is not unprecedented. LIBOR itself, in the space of a few years, replaced funding linked to T-bill rates, which was the norm before 1986.
Between now and January 2022, central banks need to provide substantially more liquidity in order to mitigate the inherent volatility of overnight funding markets. The recent Fed announcement of its intention to expand its balance sheet might appear to be another round of quantitative easing, but its effect is more akin to the oiling of a rusty piece of machinery.
The chart below shows unsecured overnight rates and IOER. During the last year, the unsecured rate has consistently been higher than IOER, reflecting a general reduction in money-market liquidity. This has been driven by the official policy of the Fed.
While the Fed may be primarily to blame, the recent hiatus in SOFR may also be due to a technical shortage of liquidity for specific institutions, even as bank reserves, in aggregate, remain elevated. This points to a more intractable problem with the credit transmission mechanism. In a recent Fed Senior Financial Officer Survey, 80 respondent banks were asked “what they believe is the lowest comfortable level of reserve balances.” The actual reserves of these institutions were roughly double the financial officers’ estimates.
Looking at data for overnight transactions, it appears that a small number of institutions are being forced to pay prohibitive premia to borrow from their peers. Whether or not there is another Bear Stearns or Lehman Brothers lurking in the shadows ready to take down the financial system in a redux of 2007–8 is not clear, but fear among senior financial officers is palpable.
In terms of the Fed’s response to the recent squeeze in overnight rates, the New York Fed responded on October 23 with the following “Statement Regarding Repurchase Operations”:
The Desk has released an update to the schedule of repurchase agreement (repo) operations for the current monthly period. Consistent with the most recent FOMC directive, to ensure that the supply of reserves remains ample even during periods of sharp increases in non-reserve liabilities, and to mitigate the risk of money market pressures that could adversely affect policy implementation, the amount offered in overnight repo operations will increase to at least $120 billion starting Thursday, October 24, 2019. The amount offered for the term repo operations scheduled for Thursday, October 24 and Tuesday, October 29, 2019, which span October month end, will increase to at least $45 billion.
One of the essential functions of the Fed is to provide sufficient liquidity to all parties throughout the financial system. The increase in overnight and term repo liquidity will maintain the semblance of stability, but the underlying distrust between banks means that only a fraction of this new liquidity will reach the real economy. Where it may appear is in the bond and stock markets. As with other Fed balance sheet expansions, assuming it is not entirely re-deposited with the Fed, the additional liquidity will have to go somewhere. Asset prices are likely to benefit, and the most liquid assets will benefit most.
How much of the current liquidity shortage is related to the disbanding of LIBOR? This is difficult to judge. What seems likely is that LIBOR will be replaced by a range of different benchmark rates in order to meet the needs of the financial markets. Risk-free rates and even unsecured overnight rates do not capture the fluctuations in the marginal funding costs of financial intermediaries.
As the BIS describes it, there is no “Swiss army knife solution.” They envisage the coexistence of multiple rates. This fragmentation will reduce liquidity and increase volatility, requiring yet more secured liquidity to be provided by central banks. The BIS concludes its review of LIBOR replacements thus:
The jury is still out on whether any resulting market segmentation would lead to material costs and inefficiencies, or whether this “new normal” might actually be optimal.
Given the degree of uncertainty expressed by as illustrious an institution as the BIS, it seems likely that QE4 is only just beginning.