Photographer: Chris Ratcliffe/Bloomberg

Libor Lied. Here’s Why Replacing It Isn’t Easy: QuickTake Q&A

The scandal-ridden London interbank offered rate, or Libor, may be on its last legs. After more than two years of study, a U.S. Federal Reserve-sponsored group on June 22 recommended replacing the interest-rate benchmark with one based on the bustling Treasury repurchase, or repo, market. That’s where banks overnight exchange their U.S. Treasury bonds for cash, then buy the securities back the next day. The new rate eventually could be the benchmark for pricing some $300 trillion of U.S. derivatives, student loans, home mortgages and many other types of credit. It could take years to transition to the new rate from Libor, an integral part of the global financial system for decades but that turned out to have numerous vulnerabilities.

1. What’s the problem with Libor, anyway?

Lots. It was set up by the London-based British Bankers Association in 1986 as a way to price syndicated loans and interest-rate swaps. The rate was determined by a daily poll, which asked banks to estimate how much it would cost to borrow from each other without putting up collateral. Because fewer banks make such unsecured loans, Libor doesn’t always reflect actual practice. And because it doesn’t always reflect actual transactions, either, it’s prone to manipulation. Regulators and prosecutors, after the 2008 financial crisis, found that dozens of firms worldwide had colluded to set the benchmark at levels that would benefit their own Libor-linked portfolios. Large European and U.S. banks paid billions of dollars to settle rigging and other charges.

2. What is the new reference rate?

The Alternative Reference Rates Committee, made up of Wall Street banks and regulators, decided to use a rate based on the cost of overnight loans that use U.S. government debt as collateral. The Federal Reserve Bank of New York plans to publish daily what it calls a broad Treasury repo rate, in cooperation with the U.S. Treasury Department’s Office of Financial Research, starting in the first half of 2018. For now, it’s providing historical data.

3. How will the new rate be calculated?

It will include data from actual transactions throughout the repo market. Some of the data, for example, will come from the so-called tri-party market, where a third party, the Bank of New York Mellon, clears transactions between two other parties. Other data will come from inter-dealer transactions cleared by the Wall Street-owned Depository Trust & Clearing Corp. Some deals done directly between two parties, or bilateral transactions, will also be included. The benchmark will exclude the Fed’s own repo transactions.  

4. Why is the new rate better than Libor? 

One big reason is that it will reflect real, not hypothetical, transactions and thus may be impossible to manipulate. The broad repo rate is based on about $660 billion in daily transactions. Another improvement: By counting only secured loans, the new rate will reflect a more prevalent form of financing. 

5. What happens next?

Later this year the rates committee will give further details to guide derivatives-market participants, which include hedge funds, asset managers, banks, swap dealers and insurance companies, to the new rate. The committee will also detail how it plans to align other parts of the financial system and create futures and money-market derivatives, known as overnight index swaps, that will depend on the new rate.

6. How long will the switch take?

It could take many years. Ruslan Bikbov and Jason Williams, strategists at Citigroup Inc., say that since other derivatives linked to the broad repo rate need to be created from scratch, it could take as many as five years to phase Libor out.

7. Does everyone expect this to work?

Many have raised doubts that the new rate will fully muscle out Libor, despite its flaws. Scott Peng, the Citigroup strategist who in 2008 first brought attention to Libor’s problems, says the repo benchmark “will not succeed.” Peng, the founder and chief executive officer of Advocate Capital Management LLC, says one problem is that the new benchmark’s overnight maturity doesn’t align with the most popular maturities -- one and three months -- that investors now use when locking in rates. Other strategists say the new rate will only serve as a backup, in the event of disruption to Libor.

8. What if it fails to catch on?

Libor will probably continue. Intercontinental Exchange Inc., the Atlanta-based owner of stock exchanges and futures markets, in 2014 assumed oversight of Libor and made important changes, such as basing more of the rate on actual transactions. Still, U.S. regulators see risks in a benchmark prone to mispricing and based on fewer and fewer unsecured loans, which is why they want to replace it.

The Reference Shelf

  • A QuickTake explainer on benchmarks and the battle against financial fiddling.
  • The Alternative Reference Rate Committee’s June 2017 presentation materials.
  • ARRC’s interim report on benchmark selection process.
  • OFR’s guide to understanding the U.S. repo and securities lending markets.
  • A story detailing the unfolding of the Libor scandal.
  • An excerpt from "The Fix: How Bankers Lied, Cheated and Colluded to Rig the World’s Most Important Number" by Bloomberg reporters Liam Vaughan and Gavin Finch.

— With assistance by Alex Harris, and Matthew Boesler

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