A 2012 report commissioned by the UK government recommended—as a result of what the report described as “alleged misconduct relating to LIBOR [the London interbank offered rate] and other benchmarks”—that changes be made to the administration and oversight of LIBOR. The report, The Wheatley Review of LIBOR,1 proposed that in the immediate term “LIBOR should be reformed, rather than replaced.”2 In response to the Wheatley Review, in 2013 LIBOR quotations were discontinued for certain currencies and certain maturities, and in February 2014, ICE Benchmark Administration replaced the British Bankers’ Association as the administrator of LIBOR.
In contrast to the Wheatley Review’s focus on LIBOR reform,3 US regulators have almost from the beginning of the investigations signaled the need to replace LIBOR. The Financial Stability Oversight Council (FSOC), a US government organization created by the Dodd-Frank Wall Street Reform and Consumer Protection Act,4 pointed out in its 2013 annual report5 that there has been a continued decline in banks’ funding themselves with unsecured short-term funding—the funding market that is the source of LIBOR quotations. As that decline continues, US regulators are concerned that at some point there will be insufficient trading volume and liquidity to support the use of LIBOR as a benchmark interest rate.
In response to recommendations6 made by the FSOC, in November 2014 the Federal Reserve Board and the Federal Reserve Bank of New York convened an Alternative Reference Rates Committee (“ARRC” or “Committee”) to identify a reference rate that could replace LIBOR. The voting members of the ARRC include US and non-US banks; non-voting members include the International Swap and Derivatives Association, Inc. The ARRC is charged with (a) coming up with one or more alternative reference rates and (b) developing a plan for adoption of a new reference rate or rates.
After considering six different interest rate bases, in May 2016 the Committee identified two potential rates as the strongest possible alternatives to LIBOR:7
- A rate based on the overnight unsecured bank borrowing market. The Federal Reserve Bank of New York currently publishes one such rate—the Overnight Bank Funding Rate (OBFR)—based on data from over 150 banks active in the United States.8
- A rate based on the overnight secured Treasury general collateral repurchase agreement rate (the GC repo rate). Although this rate is currently published by private sources, the ARRC has expressed a preference for a rate calculated and published by the public sector. In November 2016 the Federal Reserve Bank of New York announced that it was considering publishing (starting in late 2017 or early 2018) three rates based on the overnight Treasury GC repo rate.9
US regulators believe that both of these rates are “… more robust and resistant to manipulation …” than is LIBOR.10
Any movement away from LIBOR for US dollar transactions—howsoever staged and whatever its initial scope—will have profound implications for financial markets throughout the world. The work that the Committee has done to date to effect that movement gives rise to at least three questions:
What benchmark rate will the ARRC select, and when will it make its selection public?
At the Committee’s December 1, 2016 meeting, it agreed that one of its high-level priorities for 2017 would be to finalize its selection of a single alternative overnight reference rate to recommend to the market.11 But the Committee has also said that choosing the right rate is important and that it won’t be rushed into making a decision.
Is the benchmark rate intended to apply only to derivative products or also to loan products?
The Federal Reserve Bank of New York believes that almost 90 percent of the outstanding gross notional value of financial products referencing LIBOR is represented by interest rate derivatives, and much of the discussion within the Federal Reserve Board and in the Committee appears to have focused on the use of an alternative benchmark rate in derivative transactions. While derivatives are the regulators’ key target for transition to an alternative rate (and the transition strategies so far announced focus almost exclusively on the derivatives market), and there is little discussion by the regulators about how a new benchmark rate would affect loan products, regulators appear to believe that corporate loans and other lending products will also eventually transition from LIBOR to the chosen replacement rate.12 13
How will the transition from LIBOR to the new benchmark rate take place?
Although the Committee has described the “basic steps” in a “paced transition” to a new benchmark interest rate,14 there is very little in the way of a detailed description of how the market would transition from LIBOR. To appropriately prepare for the transition to a new benchmark, the financial markets will be looking for more substantive and complete information about how to make the transition.
*****1 The Wheatley Review of LIBOR: final report, September 2012, H.M. Treasury.
2 Id. at 43.
3 Note that the Bank of England has convened a Working Group on Sterling Risk-Free Reference Rates to select an alternative reference for pounds sterling.
4 US Department of the Treasury, Treasury, https://www.treasury.gov/initiatives/fsoc/Pages/home.aspx (last visited April 10, 2017).
5 Financial Stability Oversight Council, 2013 Annual Report, June 2013 at 6.
6 Alternative Reference Rates Committee (2016), Interim Report and Consultation (New York: ARRC, May), https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2016/arrc-interim-report-and-consultation.pdf?la=en.
8 The Federal Reserve Bank of New York has described OBFR as “… a broad measure of US dollar funding costs for US-based banks … calculated using both fed funds and Eurodollar transactions.” Marco Cipriani, Julia Gouny, Matthew Kessler, and Adam Spiegel, Liberty Street Economics, The New Overnight Bank Funding Rate, http://libertystreeteconomics.newyorkfed.org/2015/11/the-new-overnight-bank-funding-rate.html (Nov. 9, 2015).
9 Federal Reserve Bank of New York, Statement Regarding the Publication of Overnight Treasury GC Repo Rates, November 4, 2016.
10 Sally Bakewell, Bloomberg, Scandal-Ridden Libor’s Substitute on Tap for 2017 Treasury Says, https://www.bloomberg.com/news/articles/2016-12-07/scandal-ridden-libor-s-substitute-on-tap-for-2017-treasury-says (Dec. 7, 2016).
11 Richard Berner, Financial Research, TIME IS RIGHT FOR LIBOR ALTERNATIVE, https://www.financialresearch.gov/from-the-director/2016/12/08/time-is-right-for-libor-alternative (Dec. 8, 2016).
12 See, e.g., Jerome Powell, Governor, Fed. Reserve at the Money Marketeers of New York University (Sept. 4, 2014); See Frequently Asked Questions: the ARRC Interim Report, “… institutions should consider moving away from LIBOR [with respect to loans]” because “… the structural integrity of USD LIBOR has been challenged as the scarcity of underlying transactions poses a continuing risk of discontinuity or even cessation in the production of USD LIBOR.” See generally, Market Participants Group on Reforming Interest Rate Benchmarks: Final Report (May 2014).
13 The Committee’s choice of overnight rates will present challenges to any transition to its proposed alternative benchmark rate since loan products currently typically accrue interest at LIBOR rates for a term (one, two, three or six months), and not at an overnight rate.
14 Alternative Reference Rates Committee (2016), Interim Report and Consultation (New York: ARRC, May), https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2016/arrc-interim-report-and-consultation.pdf?la=en.