A Plethora of New Reference Rates

Thom Thompson

Thom Thompson

Contributing Editor

Ameribor is not the only new short-term interest rate vying for market attention. As part of the post-financial crisis reforms, global regulators are overseeing the abandonment of LIBOR, the London Interbank Offer Rate, in favor of new short-term interest rate indicators that they hope will supplant LIBOR rates, especially as the bases for OTC swap contracts. 

The Financial Stability Board, representing the financial regulators from the G20 countries, was challenged by the emergence of evidence of rate-rigging in the global LIBOR markets during the 2008 financial crisis as the result of a lawsuit filed by Charles Schwab. Today there are recognized, government endorsed replacements for euro, yen, Swiss franc, dollar and pound LIBOR rates trying to push the incumbents aside. They are, respectively, ESTER,TONAR, SARON, SOFR and SONIA.

LIBOR is derived from a survey of major banks doing business in the London interbank market. It developed originally as a very informal indicator and, over time, grew in its usefulness – for example, as the basis for futures and swaps contracts – and in prominence as providing the globally quoted benchmarks for short-term interest rates. $400 trillion worth of contracts are reportedly tied to LIBOR rates today. Clearly, the rates are popular even if the methodology for setting them has been questioned. 

LIBOR rates reflect the rate at which the major dealing banks are willing to lend the various currencies for 30-day, 90-day and other short terms. They are free market-determined, commercial interest rates that are used for commercial financing. 

The new rates, in contrast, are not only government-endorsed, they are also government-run. LIBOR rates were administered by the British Bankers Association and later moved out from under the cloud that formed around the association after the financial crisis to ICE Benchmark Administration. The replacements are administered officially by government agencies. SARON, the Swiss one that will be run by the stock exchange, is the exception. LIBOR rates are the basis of a number of government-sanctioned financial products like the CME Group’s eurodollar futures, and  LIBOR rates are generally based on quotes from government-regulated banks. They have not been subject to direct regulation. 

SOFR, the U.S.’s LIBOR replacement, uses data from overnight Treasury repurchase agreements that are either cleared or transacted at Bank of New York Mellon. These platforms allow non-bank entities to transact, broadening the representativeness of the index. About the switch to an overnight rate from 30-day and 90-day time horizons, the U.S. Office of Financial Research said, “Because repos are a key source of short-term funding in the financial system, a rate based on these transactions is a good candidate for an alternative reference rate.” 

All of the new interest rates are based on transactions rather than quotes or surveyed indications of interest. This should help at least the appearance of integrity for the new rates against the backdrop of the LIBOR rate fixing scandals.

Moving to overnight rate-based instruments from short term rate contracts and products increases the basis risk for commercial users, which do not participate as greatly in overnight interest rate markets compared to banks and major financial institutions. It will be interesting to see how (or maybe, if?) SOFR-adjacent products and markets develop to address different term-structures. Kurt Dew, a consultant who attended the birth of eurodollar futures as an economist at the CME, has noted in a series of blog posts that an overnight risk-free interest rate might not be the perfect substitute for the LIBOR regime, which reflects riskier and longer term funding requirements.

As any economist would tell you, the LIBOR rates have had the benefit of originating out of commercial demand and were designed by commercial entities. A regulator would note that perhaps there have been insufficient incentives to avoid manipulation and fraud. The markets have not rushed to embrace instruments based on the new rates – although, to be fair, eurodollar and euribor products grew slowly. In the first half of this year, CME eurodollar futures, the easiest product to track in this sphere, had a 100 times greater volume than CME SOFR futures:  379 million eurodollar contracts to SOFR futures’ 3.5 million contracts. 

 

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