Learning to live without LIBOR
A RESTAURANT CHAIN in Huntsville, Ala., draws an additional a few thousand dollars from its working capital facility with a local bank. Meanwhile, its employees’ pension plan must convert the variable interest rate on $ 10 billion of its assets into a fixed income stream. The system accepts an interest rate swap with a hedge fund, which wants to bet on the Federal Reserve’s rate hike. He places the bet using a margin loan from his main broker, one of the biggest banks on Wall Street.
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Every transaction needs a benchmark to decide on the interest rate to charge. The weird thing is that they all use the same one: the London Interbank Offered Rate (LIBOR), an estimate of the rate at which London’s big banks lend in a dark corner of the money markets. Each day, it shows the borrowing costs for each of the five currencies, for periods ranging from overnight to one year. Those for the dollar alone are used to determine interest rates on $ 223 billion in debt and derivatives – more than two and a half times a year around the world GDP. But the benchmark is not long for this world. The fixings for the euro, the pound sterling, the Swiss franc and the yen will be removed at the end of 2021, and those for the dollar in June 2023. What will replace them?
LIBOR is best known for a scandal that erupted in 2012, when it emerged that banks and traders were illicitly manipulating her for years. It had become even easier after the market, it was supposed to measure almost everything evaporated. For most of the five decades since its invention, banks have used unsecured loans from peers as a source of day-to-day funding. But these dried up during the 2007-09 financial crisis and never returned to anything like their previous volume. An interbank lending market with daily transactions of around $ 500 million now underlies dollar indexed contracts LIBOR which are worth about 450,000 times more. This disparity has led regulators to call the time LIBOR in 2017.
The most striking feature of the transition is the diversity of candidates to replace it. Start with the main alternatives in each of the LIBORthe five currencies. This is the guaranteed overnight funding rate (SOFR) for the dollar, the average of the daily sterling index (SONIA) for the pound, the Tokyo overnight average rate (TONAR) for the yen, the average Swiss overnight rate (SARON) for the Swiss franc and the short-term euro rate (€STR) for the euro. All of them are so-called “near risk-free” rates, which measure the cost of day-to-day loans. But they do so in different ways, which reflect local funding conditions. British, European and Japanese banks rely on unsecured deposits for their overnight liquidity. Therefore SONIA, € STR and TONAR are daily averages of the rates that banks pay on these deposits. But the big American and Swiss banks tend to rely more on pensions (loans guaranteed by government bonds). Therefore SOFR and SARON rather, measure transactions in these markets.
A new fragmentation is emerging in the dollar market. SOFR is less useful for the Alabama regional bank that lends to local businesses because it is unlikely to be a heavy user of pensions. These lenders tend to be more dependent on unsecured short-term debt which is no different from the underlying LIBOR, but at rates set for small banks in the local market rather than large ones in London. Hence the creation of AMERIBOR, an index that measures the borrowing costs of small, medium and regional banks in America. Two indices produced by Bloomberg, a financial data company, and the Intercontinental Exchange (ICE CREAM), aim to perform a similar function for large banks which derive part of their funding from long-term bonds rather than short-term repo’s, and who wish to lend using a benchmark reflecting their normal borrowing costs .
These alternatives to SOFR may be better suited for certain types of lenders, but they have two drawbacks. The first is that they could be too LIBOR-like. Thomas Wipf of the Alternative Reference Rates Committee (ARRC), a body convened by the Federal Reserve to steer the dollar market’s transition, warns against resorting to benchmark rates that could LIBORgaps. A bespoke index representing bank funding costs may seem like a good idea, until a liquidity crunch occurs and the underlying transactions dry up, making it volatile in times of stress. SOFR, which is based on over $ 1 billion in daily repo transactions, was chosen by the ARRC to avoid precisely this possibility. On the other hand, AMERIBOR and ICE CREAMThe Bank Performance Index is supported by transactions valued at $ 2.5 billion and $ 15 billion, respectively.
The second concern is liquidity, and therefore trading costs, in markets indexed to more suitable benchmarks. Under LIBOR—And, in the future, SOFR—Huntsville restaurant chain has access to the same derivative market as the hedge fund. This large trading pool means that small businesses can buy contracts to protect themselves from rising interest rates at a relatively low price. AMERIBOR may come closer to regional lender funding costs, but debt and derivatives trading related to this niche criterion is likely to be slower and more expensive.
These flaws could mean that some of the new benchmarks are falling into disuse. Yet on the whole, the constellation of successors of LIBOR seems like a good thing. It is fundamental to the concept of debt that the costs of borrowing depend on who you are, your lender, and the currency in which you borrow. The new measures should do a better job than a relic of little relevance to the current financial system. ■
This article appeared in the Finance & Economics section of the print edition under the title “Learning to live without LIBOR”