Amid the investigations into manipulation of Libor, policymakers are coming around to the idea that the world needs a new benchmark to price hundreds of trillions of dollars in loans, securities, and derivatives. The challenge will be getting banks, investors, and borrowers to agree on what that benchmark should be.
Libor’s flaws are now abundantly clear. Instead of gleaning information from actual transactions, Libor relies on banks to report their borrowing costs honestly, something they spectacularly failed to do. And the market it supposedly measures—interest rates on short-term loans among banks, unsecured by collateral—tends to disappear in times of crisis, making the rates no more than estimates.
It’s encouraging that the world’s central bankers are zeroing in on some possible replacements, at least for U.S. dollar Libor, which is the most widely used of the Libor benchmarks. Federal Reserve Chairman Ben Bernanke has mentioned two leading candidates: overnight index swaps and the general collateral repo index. Neither rolls off the tongue, but one is a significant improvement.
Overnight index swaps are contracts based on the so-called federal funds effective rate, which is the interest U.S. banks charge one another on overnight loans. The Fed records the underlying loans and publishes a weighted average interest rate every day. Problem is, banks tend to pull out of the market during times of stress, leaving it too small and too easily skewed to provide a true picture of borrowing costs.
The general collateral repo index looks like a better option. It tracks the very large market for repurchase agreements, known as repos, typically overnight loans made against good collateral such as U.S. Treasuries. The Depository Trust & Clearing Corp. publishes a daily weighted average of the actual interest rates paid on these loans. Aside from being secured by collateral, a large portion of the loans are processed through a central counterparty that protects the system against default by any one participant.
Establishing a new benchmark won’t be easy. For a repo index to gain widespread acceptance, a market must grow up around it. And investors and dealers won’t want to hold securities tied to the index until there is a robust derivatives market providing them opportunities to hedge their holdings. Last week, NYSE Euronext initiated futures contracts on the repo index, and banks are signing up to trade interest-rate swaps. Even so, the derivatives will have a hard time gaining critical mass until a lot of securities have been issued. It’s the classic chicken-and-egg problem.
Here, the U.S. government’s debt load can be an advantage. The U.S. Treasury could (as it has suggested it might) issue floating-rate notes—that is, new government bonds whose interest rates would fluctuate with the repo index. As banks’ and investors’ holdings of the notes grew, so would their demand for derivatives.
Ultimately, the best way to deal with Libor’s flaws is to move to a better benchmark. Repo looks like a big part of the answer.