Replace Fed Funds Rate With New Benchmark, Bond Market Says

  • RMA, SIFMA recommend transition to overnight bank funding rate
  • Fed funds rate `slowly fading into irrelevance': Credit Suisse

U.S. fixed income market participants should begin using a new benchmark the Federal Reserve introduced earlier this year to replace the federal funds rate when pricing derivatives contracts, two industry groups said Wednesday.

The Federal Reserve Bank of New York introduced the overnight bank funding rate earlier this year to provide an alternative to the fed funds rate, which the U.S. central bank targets for monetary policy decisions, because turnover in fed funds has dwindled since the financial crisis.

“The Risk Management Association and the Securities Industry and Financial Markets Association have announced that each recommends the use of the Federal Reserve Bank of New York’s new Overnight Bank Funding Rate as a benchmark for pricing and performance reporting purposes to replace the Fed Funds Open (FFO) rate,” the two groups said in a joint statement.

Transaction volumes in the fed funds market have shrunk dramatically since 2008, when the Fed began injecting bank reserves into the financial system as a byproduct of asset purchases to boost U.S. growth after short-term interest rates were reduced to near zero.

Fed funds volume has averaged $68 billion per day since the New York Fed began publishing data in March. The overnight bank funding rate adds roughly $220 billion of daily transactions in the euro-dollar market to broaden the base on which the rate is calculated, in order to make it more robust.

Slow Fade

“The fed funds market is slowly fading into irrelevance,” said Zoltan Pozsar, director of economics at Credit Suisse Securities USA LLC. “Whatever is left of the fed funds market today is too small in volume and has too few participants to provide a trustworthy reference rate to base trillions of dollars worth of derivatives off of.”

If market participants transition from using the fed funds rate as a primary benchmark, the Fed may also want to adopt the overnight bank funding rate as its main policy target, Pozsar, a former researcher at the New York Fed, said.

RMA, which represents banks, and Sifma, the main trade association for securities dealers and money managers in the U.S., are leading voices in the industry. Their proposal comes as the Fed is undertaking a review of long-run operating frameworks for monetary policy.

Simon Potter, who heads the New York Fed’s markets group tasked with implementing interest rate decisions, said earlier Wednesday that officials are “asking ourselves what the best way of implementing monetary policy is today and in future environments in a manner that is consistent with the Federal Reserve’s normalization principles.”

The Treasury Market Practices Group, an advisory committee backed by the Federal Reserve Bank of New York, endorsed the recommendations by Sifma and the RMA in a statement on Wednesday.

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