(Reuters) - A bank committee on Thursday will vote on an alternative U.S. interest rate to Libor to use a reference in trillions of rate derivatives.
The two rates under proposal are the Overnight Bank Funding Rate and a rate based on overnight lending in the U.S. Treasury collateral-based repurchase agreement market.
The following are some facts about why an alternative rate is being created:
What is Libor?
The London Interbank Offered Rate (Libor) began in the 1970s in London as the rate that U.S. banks would lend to each other, and was used as a reference rate for corporate bank loans. In the 1980s the rate began being published as an average rate of a group of banks.
The growth of interest rate derivatives since the 1980s made it easier to hedge Libor-based loans, helping spread the use of the rate to products ranging from student loans to credit cards.
The rate underpins more than $3 trillion in syndicated loans, around $1.5 trillion in commercial mortgages and $1.44 trillion in residential mortgages, and another $2.5 trillion in mortgage-backed securities and other asset-backed securities, according to a report by the Financial Stability Board’s Market Participants Group in 2013.
The largest exposures, however, are in derivatives. Libor is used as a reference rate in around $111 trillion privately traded derivatives and an additional $30 trillion in exchange-traded derivatives.
Why do they want an alternative?
Libor lost credibility as a benchmark after banks including Barclays, Deutsche Bank and UBS were, since 2012, fined by U.S. and British authorities for manipulating Libor submissions, in many cases to boost profits on their derivatives positions.
ICE Benchmark Administration, which took over administration of Libor from the British Bankers’ Association in 2014, has implemented reforms to shore up the rate and reduce its susceptibility to manipulation.
Libor is still viewed as fragile, however, as regulatory reforms since the 2007-2009 financial crisis have resulted in banks making fewer short-term loans to each other. Money fund reform has also reduced demand for short-term bank debt. That means the rates are often estimated and not transaction based.
Data by ICE shows that only around 30 percent of U.S. dollar based three-month Libor submissions are based on actual transactions.
Is the United States the only country looking for an alternative rate?
No. Regulators have pushed internationally to find alternatives to Libor and its equivalents. A British committee has selected SONIA, an unsecured overnight lending rate, as an alternative to sterling-based Libor and Japan last year selected TONAR as an alternative to yen Libor, also an unsecured rate. A group in Switzerland in May selected SARON, a collateralized rate based on the Swiss repo market, as a Libor alternative.
The European Central Bank said in May it is ready to work on its own index of bank-to-bank lending after an industry-led revamp of Euribor failed.
Will the new rate immediately replace Libor?
No. Regulators and market participants expect a very slow transition to the new interest rate and it is likely to take years to develop liquidity in markets referencing the new rate.
What are the differences between the two proposed rates?
The Overnight Bank Funding Rate (OBFR) is an unsecured rate, meaning that there is no collateral exchanged to back the loan. The rate is a volume-weighted median of overnight fed funds and Eurodollar transactions. Around $70 billion fed funds transactions are made per day and around $240 billion Eurodollar trades are made overnight.
The overnight repurchase market is secured, with borrowers pledging Treasuries to back the loans. The so-called repo market is estimated to have more than $600 billion in trades made overnight.
What are the pros and cons of each?
Analysts at TD Securities note that an advantage of using the OBFR is that interest rate swaps currently use the Effective Fed Funds Rate (EFFR), which is based on fed funds transactions, to value payments and the OBFR and EFFR rates are very similar. A swaps market referencing the EFFR, the overnight index swap (OIS) market, also already exists.
Disadvantages are that volumes in the OBFR market have been declining and volumes drop significantly around quarter- and year-end, TD said.
The advantages of using a repo rate is that the market is more liquid. Disadvantages, however, are that the exact rate that would be used does not yet exist, which could potentially make for a longer and more complicated transition, the TD analysts said.
Reporting by Karen Brettell; Editing by Meredith Mazzilli