Tag: LIBOR

BBSW “Elastic” Stretches Again

The benchmark BBSW rate has moved higher again, with the 3 month series now at a high of 2.1185; up ~36 basis points from February.

We know that around 20% of bank funding is from short term sources, according to the RBA.

Of that, more is sourced offshore than onshore. Both overseas rates – as typified by the US LIBOR …

… and the local BBSW rates as we looked at before, suggest a hike in mortgage rates is coming. In fact more smaller lenders quietly lifted their rates last week, following Suncorp, ME Bank and others.

IMB Bank said  from 22 June, its standard variable interest rate will increase by 0.08 per cent for new and existing home loan customers and Auswide has also lifted with increases of five basis points (0.05%) for owner occupied home loans and thirteen basis points (0.13%) for investment home loans and residential lines of credit, effective 27th June.

Unless the majors follow suite, expect their profits to drop, and returns of bank deposit to fall further.

US Mortgage Rates continue higher too…

The Problem With LIBOR

The cost of money continues to rise, and this includes the LIBOR benchmark rate, as shown by this chart. LIBOR or ICE LIBOR (previously BBA LIBOR) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans. As it climbs, it signals rate rises ahead.

But what is LIBOR, and more importantly, will it survive?

ICE LIBOR stands for Intercontinental Exchange London Interbank Offered Rate and serves as the first step to calculating interest rates on various loans throughout the world. LIBOR is administered by the ICE Benchmark Administration (IBA) and is based on five currencies: the U.S. dollar (USD), euro (EUR), pound sterling (GBP), Japanese yen (JPY), and Swiss franc (CHF). The LIBOR serves seven different maturities: overnight, one week, and 1, 2, 3, 6 and 12 months. There is a total of 35 different LIBOR rates each business day. The most commonly quoted rate is the three-month U.S. dollar rate (usually referred to as the “current LIBOR rate”), as shown in the chart.

So, LIBOR is the key interest rate benchmark for several major currencies, including the US dollar and British pound and is referenced in around US$350 trillion worth of contracts globally. A large share of these contracts have short durations, often three months or less. But it’s up for a shakeout as RBA Deputy Governor Guy Debelle Discussed recently.

Last year, the UK Financial Conduct Authority raised some serious questions about the sustainability of LIBOR. That is, apart from the rate fixing problems and the ensuing large fines.

The key problem is that there are not enough transactions in the short-term interbank funding market to reliably calculate the benchmark. In fact, the banks that make the submissions used to calculate LIBOR are uncomfortable about continuing to do this, as they have to rely mainly on their ‘expert judgment’ in determining where LIBOR should be rather than on actual transactions. To prevent LIBOR from abruptly ceasing to exist, the FCA has received assurances from the current banks on the LIBOR panel that they will continue to submit their estimates to sustain LIBOR until the end of 2021. But beyond that point, there is no guarantee that LIBOR will continue to exist. The FCA will not compel banks to provide submissions and the panel banks may not voluntarily continue to do so. There is no guarantee at all that will be the case.

So market participants that use LIBOR need to work on transitioning their contracts to alternative reference rates. The transition will involve a substantial amount of work for users of LIBOR, both to amend contracts and update systems. The process is not straightforward. A large share of these contracts have short durations, so these will roll off well ahead of 2021, but they should not continue to be replaced with another short-dated contract referencing LIBOR. A very sizeable number of current contracts would extend beyond 2021, with some lasting as long as 100 years.

So regulators around the world have been working closely with the industry to identify alternative risk-free rates that can be used instead of LIBOR. These alternative rates are based on overnight funding markets since there are plenty of transactions in these markets to calculate robust benchmarks. Last month, the Federal Reserve Bank of New York began publishing the Secured Overnight Financing Rate (SOFR) as the recommended alternative to US dollar LIBOR. For the British pound, SONIA has been identified as the alternative risk-free rate, and the Bank of England has recently put in place reforms to ensure that it remains a robust benchmark.

But these chosen risk-free rates are overnight rates, while the LIBOR benchmarks are term rates. Some market participants would prefer for the LIBOR replacements to also be term rates. While the development of term risk-free rates is on the long-term agenda for some currencies, they are unlikely to be available anytime soon. This reflects that there are currently not enough transactions in markets for term risk-free rates – such as overnight indexed swaps (OIS) – to support robust benchmarks. Given this reality, it is very important that users of LIBOR are planning their transition to the overnight risk-free benchmarks that are available, such as SOFR for the US dollar and SONIA for the British pound.

For the risk-free rates to provide an alternative to LIBOR, the next challenge is to generate sufficient liquidity in derivative products that reference the risk-free rates. This will take some time, particularly for the US dollar, where SOFR only recently started being published. Nevertheless, progress is being made, with the first futures contracts referencing SOFR recently being launched.

Market participants also need to be prepared for a scenario where the LIBOR benchmarks abruptly cease to be published. In such an event, users would have to rely on the fall-back provisions in their contracts. However, for many products the existing fall-back provisions would be cumbersome to apply and could generate significant market disruption. For instance, some existing fall-backs involve calling reference banks and asking them to quote a rate. To address this risk, the Financial Stability Board has encouraged ISDA to work with market participants to develop a more suitable fall-back methodology, using the risk-free rates that have been identified. But LIBOR is very different from an overnight risk-free rate as it includes bank credit risk and is a term rate. So the key challenge is to agree on a standard methodology for calculating credit and term spreads that can be added to the risk-free rate to construct a fall-back for LIBOR. This needs to be resolved as soon as possible, and we encourage users of LIBOR to engage with ISDA on this important work.

Finally, In Australia, the key InterBank Offer Rate benchmark for the Australian dollar is BBSW. Again we saw a spate of rate manipulations around BBSW, but the RBA and the Australian Securities and Investments Commission (ASIC) have been working closely with industry to ensure that it remains robust. The RBA argues the critical difference between BBSW and LIBOR is that there are enough transactions in the local bank bill market each day to calculate a robust benchmark. Australia has an active bank bill market, where the major banks issue bills as a regular source of funding, and a wide range of wholesale investors purchase bills as a liquid cash management product.

They think that BBSW can continue to exist even if credit-based benchmarks, such as LIBOR, are discontinued in other jurisdictions. But in the event that LIBOR was to be discontinued, with contracts transitioning to risk-free rates, there may be some corresponding migration away from BBSW towards the cash rate. This will depend on how international markets for products such as derivatives and syndicated loans end up adapting in a post-LIBOR world.

The infrastructure is already in place for BBSW and the cash rate to coexist as the key interest rate benchmarks for the Australian dollar. The OIS market is linked to the cash rate and has been operating for almost 20 years. It already has good liquidity at the short end, and the infrastructure is there for longer term OIS. A functioning derivatives market for trading the basis between the benchmarks is important for BBSW and the cash rate to smoothly coexist. Such a basis swap market is also in place, allowing market participants to exchange the cash flows under these benchmarks.

So the bottom line is that these Interbank Offer Rates are not as immutable as might be imagined, and this uncertainty is likely to continue for some time to come.

Interest Rates Are On Their Way Up

Three quick charts which highlight the upward pressure on rates globally. First the T10 US Bond.

Next the average 30-Year US Fixed Mortgage Rate. Again, going higher.

And third, the LIBOR inter-bank rate – a key benchmark which drives interbank funding costs and derivatives pricing.

Marketwatch said:

The London interbank offered rate, known by the acronym Libor, is back on investors’ radar.

Libor reflects what banks charge to borrow dollars from each other and is used as a benchmark for trillions of dollars worth of loans. The rise is nothing like the panic mode of 2008, when soaring Libor reflected a reluctance by banks to lend to each other, reflecting stress in the system and fueled fears of an existential threat to the global banking system.

But the increase is seen tightening financial conditions. Also on the radar is the sharp widening of the spread between Libor and the overnight index swap rate as three-month Libor moved above 2% for the first time since 2008.

“What this means is that rates on more than $350 trillion of debt and derivatives contracts hitched to the U.S. benchmark are on the rise,” said David Rosenberg, chief economist and strategist at Gluskin Sheff, in a Monday note.

“Overleveraged entities will be in for a spot of trouble. We have a situation where half of the investment-grade bond market in the USA is BBB,” he wrote. BBB is the second-lowest investment grade rating by S&P Global Ratings and Fitch Ratings.

In 2016, Libor rose in response to money-market reforms.

The catalyst for the more recent rise, and widening of the Libor-OIS spread, is placed by economists and analysts partly on the U.S. tax legislation signed into law in December. The repatriation of cash held overseas has led to U.S. firms pulling money out of foreign dollar funds, analysts said.

In addition to the suspected return of overseas cash, the financial system is also adjusting to a world of less Federal Reserve-provided liquidity as the central bank unwinds its balance sheet, wrote George Goncalves, head of fixed-income strategy at Nomura, in a late February note.

Meanwhile, analysts will be watching the Libor-OIS spread with the idea that a stubborn widening—and the resulting tightening of financial conditions—could affect the pace of Federal Reserve tightening in the year ahead. Rising Libor in 2016 served to tighten financial conditions, analysts said.

These rising rates spell trouble ahead in an over-leveraged world, and once again underscores that the risks are rising, and that the RBA may have to lift sooner than some expect.You can watch my recent video blog where I discuss these three charts.

Behind One of the Biggest Financial Scams in History

The LIBOR rate rigging will prove to be one of the biggest finance scans ever. Knowledge@Wharton has published an interesting post on what went on behind the scenes and how the institutions involved simply milked it.  This is just a couple of the opening paragraphs, but read the entire article over at the Wharton site or listen to the podcast.

In 2012, the global markets were rocked by revelations about a scam so massive it was almost hard to comprehend: the LIBOR (London Interbank Offered Rate) scandal. Like the U.S. federal funds rate, LIBOR is a key benchmark short-term interest rate upon which other financial instruments are based. While the target for the U.S. rate is set by the Fed, LIBOR is the average of self-reported interest rates major banks charge one another to borrow money. By colluding to manipulate LIBOR, the banks’ traders raked in a fortune by betting on assets influenced by the interest rate.

David Enrich followed the story while he was working for The Wall Street Journal and got close to the central figure in the scandal — star derivatives trader Tom Hayes. In the book, The Spider Network: The Wild Story of a Math Genius, a Gang of Backstabbing Bankers, and One of the Greatest Scams in Financial History, Enrich, now with The New York Times, shares the tale of this brazen scam on the Knowledge@Wharton show on Sirius XM channel 111.

Knowledge@Wharton: David, that’s a phenomenal book title. It covers about everything there. This book started with a series of articles you did for The Wall Street Journal several years ago.

David Enrich: That’s right. The mastermind of the LIBOR scandal was a guy named Tom Hayes, a mildly autistic mathematician who was a star trader at some of the world’s biggest banks. He was accused, at the end of 2012, of being the central figure in this scandal by both American and British prosecutors. Right around that time, I started to get to know Tom Hayes really well personally. I first interviewed him for an article that I was doing in The Wall Street Journal. Over the ensuing months and years, I’ve spent an enormous amount of time talking on the phone with him, having coffee with him, drinking beers with him. I got to know him really well, his wife really well, and the rest of his family as well. And that gave me this interesting glimpse into the world in which Hayes was operating.

Knowledge@Wharton: Was it surprising to you that you had such free access to the guy who essentially started this whole scam?

Enrich: That’s what I thought at first. I was stunned by the serendipity of the thing. This all got started because Hayes was the central person who had been accused by prosecutors. Not a whole lot was known about him, so I started talking to some of his friends and former business school classmates. One of them turned out to be pretty helpful and offered to pass on my phone number to him, with the caveat that, obviously, this guy is facing criminal charges — the last thing he’s going to do is call a reporter to talk to him.

I was in the London bureau of the Journal at the time, and I was sitting at home one evening, and my iPhone buzzed with a text message from a number I didn’t recognize. And it said, “This goes much, much higher than me. Not even the Justice Department knows the full story. I’m willing to talk to you, but I need to make sure I can trust you.” It was Tom Hayes.

He offered to meet me the following morning at a really busy train station in London outside a Burger King. He said he’d be wearing a brown leather jacket. And I’m thinking to myself that I’m stumbling into All The President’s Men or something.

Knowledge@Wharton: I was just going to say Watergate all over again.

Enrich: I’m thinking I’m Bob Woodward here. He ended up canceling the next morning because his wife had somehow seen his text messages to me, and his wife was a lawyer and thought this was a really bad idea. But the most fascinating thing to me is that what I’d thought about this at the outset was, “I cannot believe this criminal mastermind is naïve enough to be talking to me.” It turned out part of the reason he was so eager to talk to me is because the story was a lot more complicated than I had originally thought.

It wasn’t as clear-cut and black-and-white as prosecutors and regulators were portraying it, which was that he was the bad apple or the evil mastermind or evil genius who had orchestrated this scheme to rip off all these innocent people. It was much more a story about a financial system run amok, and how the overall banking system encouraged, more or less, this type of behavior not just from Hayes but from a really wide range of people, including a lot of his superiors who ended up not suffering particularly severe consequences from that.

LIBOR Transition Creates Uncertainty for SF Market

Replacing LIBOR presents challenges for the structured finance (SF) market that are likely to be addressed in the context of industry-wide initiatives, Fitch Ratings says.

The long lead time and a desire to avoid disruption to floating-rate bond markets such as SF should support the transition to standard benchmarks as successor reference rates. The impact on SF will depend on which rates are adopted, how consensual the process is across all market participants, and how they deal with technical and administrative challenges.

LIBOR is the reference rate for SF bonds and related derivatives contracts in several large SF markets. Almost all of the USD450 billion of US CLO notes outstanding reference LIBOR, as do USD186 billion of US sub-prime/Alt-A RMBS and USD24 billion of US prime RMBS. US student loan ABS commonly reference LIBOR. Elsewhere, nearly all UK RMBS reference Libor. Some underlying loans, such as leveraged loans, US hybrid adjustable-rate mortgages, US student loans, and auto loans, reference LIBOR.

Panel banks will maintain LIBOR until end-2021. This gives capital markets four-and-a-half years to agree a successor regime for the bulk of bonds currently linked to LIBOR, enabling a coordinated transition to as few benchmarks as needed. This would avoid costly ad hoc negotiations and potentially complicated bespoke transaction amendments. Loan markets may follow suit, although the risk of fragmentation geographically and by asset class could create SF basis risk in respect of existing loans, or alter the level of credit-enhancing excess spread.

There are practical challenges in co-ordinating transition. Voting rights in SF transactions, in some cases requiring majority consent of all classes of notes, may complicate any amendment process and even increase the scope for inter-creditor disputes. Trustees will also have an important role in determining what conditions are placed on transaction parties. These challenges will require effective use of the long lead time available.

To preserve liquidity, we think bond markets will generally follow initiatives in the derivatives market, where funding is hedged and discount rates determined. The International Swaps and Derivatives Association is examining fall-back provisions in LIBOR swap contracts, and working groups in some jurisdictions have recommended alternative near-risk free reference rates for the derivatives market, including the Sterling Overnight Index Average (SONIA) in the UK and the Broad Treasuries Repo Financing Rate in the US.

But it remains unclear whether the eventual successors to LIBOR will be overnight rate benchmarks or forward rate benchmarks, how far this will vary from country to country, and whether loan markets will adopt the same reference rates at the same time (reducing basis risk). At the heart of these questions is the effect on the value of currently contracted interest payments.

Any move to replace LIBOR with a benchmark that increased interest costs, particularly for retail borrowers, would face political objections. But a reduction in interest earned could also face opposition. Balancing these interests may prompt efforts to adjust margins to leave loan and bond coupons unchanged. Challenges coordinating the transition for assets and liabilities could leave SF transactions with basis risk, or change the level of excess spread. Possible consequences for ratings would also depend on the weighted average life remaining after 2021.

Commercial borrower behaviour may contribute to these risks. For example, some commercial real estate and leveraged loans include fall-back provisions aimed at managing temporary disruptions in LIBOR determination (such as polling a small panel of banks). These could make it harder to co-ordinate the transition for underlying loans and SF bonds, particularly in the leveraged loan market.

Unlike floating-rate commercial mortgages, leveraged loans are typically not hedged against interest rate risk, and may have more latitude in diverging from standardised successor benchmarks emerging from the derivatives market. If leveraged loan borrowers felt it was in their commercial interests to argue that fall-back provisions apply, basis risk would arise if CLOs moved to more liquid successor benchmarks.

After LIBOR

RBA Deputy Governor Guy Debelle spoke about Interest Rate Benchmarks at FINSA today. He made three points:

First, the longevity of LIBOR cannot be assumed, so any contracts that reference LIBOR will need to be reviewed.

Second, actions to ensure the longevity of BBSW are well advanced. While these changes entail some costs, the cost of not doing so would be considerably larger.

Third, consider whether risk-free benchmarks are more appropriate rates for financial contracts than credit-based benchmarks such as LIBOR and BBSW.

Today I am going to talk again about interest rate benchmarks, as recently there have been some important developments internationally and in Australia. These benchmarks are at the heart of the plumbing of the financial system. They are widely referenced in financial contracts. Corporate borrowing rates are often priced as a spread to an interest rate benchmark. Many derivative contracts are based on them, as are most asset-backed securities. In light of the issues around the London Inter-Bank Offered Rate (LIBOR) and other benchmarks that have arisen over the past decade, there has been an ongoing global reform effort to improve the functioning of interest rate benchmarks.

I will focus on the recent announcement by the UK Financial Conduct Authority (FCA) on the future of LIBOR, and the implications of this for Australian financial markets. I will then summarise the current state of play in Australia, particularly for the major interest rate benchmark, the bank bill swap rate (BBSW). Our aim is to ensure that BBSW remains a robust benchmark for the long term. I will also discuss the important role for ‘risk-free’ interest rates as an alternative to credit-based benchmarks such as BBSW and LIBOR.

The Future of LIBOR and the Implications for Australia

LIBOR is the key interest rate benchmark for several major currencies, including the US dollar and British pound. Just over a month ago, Andrew Bailey, who heads the FCA which regulates LIBOR, raised some serious questions about the sustainability of LIBOR. The key problem he identified is that there are not enough transactions in the short-term wholesale funding market for banks to anchor the benchmark. The banks that make the submissions used to calculate LIBOR are uncomfortable about continuing to do this, as they have to rely mainly on their ‘expert judgment’ in determining where LIBOR should be rather than on actual transactions. To prevent LIBOR from abruptly ceasing to exist, the FCA has received assurances from the current banks on the LIBOR panel that they will continue to submit their estimates to sustain LIBOR until the end of 2021. But beyond that point, there is no guarantee that LIBOR will continue to exist. The FCA will not compel banks to provide submissions and the panel banks may not voluntarily continue to do so.

This four year notice period should give market participants enough time to transition away from LIBOR, but the process will not be easy. Market participants that use LIBOR, including those in Australia, need to work on transitioning their contracts to alternative reference rates. This is a significant issue, since LIBOR is referenced in around US$350 trillion worth of contracts globally. While a large share of these contracts have short durations, often three months or less, a very sizeable share of current contracts extend beyond 2021, with some lasting as long as 100 years.

This is also an issue in Australia, where we estimate that financial institutions have around $5 trillion in contracts referencing LIBOR. Finding a replacement for LIBOR is not straightforward. Regulators around the world have been working closely with the industry to identify alternative risk-free rates that can be used instead of LIBOR, and to strengthen the fall-back provisions that would apply in contracts if LIBOR was to be discontinued. The transition will involve a substantial amount of work for users of LIBOR, both to amend contracts and update systems.

Ensuring BBSW Remains a Robust Benchmark

The equivalent interest rate benchmark for the Australian dollar is BBSW, and the Council of Financial Regulators (CFR) is working closely with industry to ensure that it remains a robust financial benchmark. BBSW is currently calculated from executable bids and offers for bills issued by the major banks. A major concern over recent years has been the low trading volumes at the time of day that BBSW is measured (around 10 am). There are two key steps that are being taken to support BBSW: first, the BBSW methodology is being strengthened to enable the benchmark to be calculated directly from a wider set of market transactions; and second, a new regulatory framework for financial benchmarks is being introduced.

The work on strengthening the BBSW methodology is progressing well. The ASX, the Administrator of BBSW, has been working closely with market participants and the regulators on finalising the details of the new methodology. This will involve calculating BBSW as the volume weighted average price (VWAP) of bank bill transactions. It will cover a wider range of institutions during a longer trading window. The ASX has also been consulting market participants on a new set of trading guidelines for BBSW, and this process has the strong support of the CFR. The new arrangements will not only anchor BBSW to a larger set of transactions, but will improve the infrastructure in the bank bill market, encouraging more electronic trading and straight-through processing of transactions. The critical difference between BBSW and LIBOR is that there are enough transactions in the local bank bill market each day relative to the size of our financial system to calculate a robust benchmark.

For the new BBSW methodology to be implemented successfully, the institutions that participate in the bank bill market will need to start trading bills at outright yields rather than the current practice of agreeing to the transaction at the yet-to-be-determined BBSW rate. This change of behaviour needs to occur at the banks that issue the bank bills, as well as those that buy them including the investment funds and state treasury corporations. The RBA is also playing its part. Market participants have asked us to move our open market operations to an earlier time to support liquidity in the bank bill market during the trading window, and we have agreed to do this.

While we all have to make some changes to systems and practices to support the new methodology, the investment in a more robust BBSW will be well worth it. The alternative of rewriting a very large number of contracts and re-engineering systems should BBSW cease to exist would be considerably more painful.

The new regulatory framework for financial benchmarks that the government is in the process of introducing should provide market participants with more certainty. Treasury recently completed a consultation on draft legislation that sets out how financial benchmarks will be regulated, and the bill has just been introduced into Parliament. In addition, ASIC recently released more detail about how the regulatory regime would be implemented. This should help to address the uncertainty that financial institutions participating in the BBSW rate setting process have been facing. It should also support the continued use of BBSW in the European Union, where new regulations will soon come into force that require benchmarks used in the EU to be subject to a robust regulatory framework.

Risk-free Rates as Alternative Benchmarks

While the new VWAP methodology will help ensure that BBSW remains a robust benchmark, it is important for market participants to ask whether BBSW is the most appropriate benchmark for the financial contract.

For some financial products, it can make sense to reference a risk-free rate instead of a credit-based reference rate. For instance, floating rate notes (FRNs) issued by governments, non-financial corporations and securitisation trusts, which are currently priced at a spread to BBSW, could instead tie their coupon payments to the cash rate.

However, for other products, it makes sense to continue referencing a credit-based benchmark that measures banks’ short-term wholesale funding costs. This is particularly the case for products issued by banks, such as FRNs and corporate loans. The counterparties to these products would still need derivatives that reference BBSW so that they can hedge their interest rate exposures.

It is also prudent for users of any benchmark to have planned for a scenario where the benchmark no longer exists. The general approach that is being taken internationally to address the risk of benchmarks such as LIBOR being discontinued, is to develop risk-free benchmark rates. A number of jurisdictions including the UK and the US have recently announced their preferred risk-free rates.

One issue yet to be resolved is that most of these rates are overnight rates. A term market for these products is yet to be developed, although one could expect that to occur through time. Another complication is that the risk-free rates are not equivalent across jurisdictions. Some reference an unsecured rate (including Australia and the UK) while others reference a secured rate like the repo rate in the US.

As the RBA’s operational target for monetary policy and the reference rate for OIS (overnight index swap) and other financial contracts, the cash rate is the risk-free interest rate benchmark for the Australian dollar. The RBA measures the cash rate directly from transactions in the interbank overnight cash market, and we have ensured that our methodology is in line with the IOSCO benchmark principles. However, the cash rate is not a perfect substitute for BBSW, as it is an overnight rate rather than a term rate, and doesn’t incorporate a significant bank credit risk premium.

Federal Reserve Board Proposes to Produce Three New Reference Rates

Given questions about the transparency of the U.S. dollar LIBOR rate benchmark, and the quest for a more robust alternative, the US Federal Reserve Board has requested public comment on a proposal for the Federal Reserve Bank of New York, in cooperation with the Office of Financial Research, to produce three new reference rates based on overnight repurchase agreement (repo) transactions secured by Treasuries.

The most comprehensive of the rates, to be called the Secured Overnight Financing Rate (SOFR), would be a broad measure of overnight Treasury financing transactions and was selected by the Alternative Reference Rates Committee as its recommended alternative to U.S. dollar LIBOR. SOFR would include tri-party repo data from Bank of New York Mellon (BNYM) and cleared bilateral and GCF Repo data from the Depository Trust & Clearing Corporation (DTCC).

“SOFR will be derived from the deepest, most resilient funding market in the United States. As such, it represents a robust rate that will support U.S. financial stability,” said Federal Reserve Board Governor Jerome H. Powell.

Another proposed rate, to be called the Tri-party General Collateral Rate (TGCR) would be based solely on triparty repo data from BNYM. The final rate, to be called the Broad General Collateral Rate (BGCR) would be based on the triparty repo data from BNYM and cleared GCF Repo data from DTCC.

The three interest rates will be constructed to reflect the cost of short-term secured borrowing in highly liquid and robust markets. Because these rates are based on transactions secured by U.S. Treasury securities, they are essentially risk-free, providing a valuable benchmark for market participants to use in financial transactions.

Comments on the proposal to produce the three rates are requested within 60 days of publication in the Federal Register, which is expected shortly.

Ex-Deutsche Bank trader pleaded guilty in U.S. to Libor scheme

According to Reuters, U.S. and European authorities investigations relating to LIBOR rate rigging have resulted in roughly US$9 billion in sanctions worldwide against financial institutions, and 16 people being charged by the Justice Department. We discussed the problem of these financial benchmarks yesterday. Now, U.S. prosecutors have secured a guilty plea from a second former Deutsche Bank AG trader for conspiring to manipulate Libor, the benchmark interest rate at the center of global investigations of various banks, court records show.

Timothy Parietti, a 50-year-old former managing director of Deutsche Bank’s New York money market derivatives trading desk, pleaded guilty on May 26 in Manhattan federal court to conspiring to commit wire fraud and bank fraud, records unsealed on Wednesday showed. According to a transcript, Parietti admitted that from 2006 to 2008, he participated in a scheme with other bank employees to manipulate Libor so that trades he made on financial instruments linked to the benchmark might be more profitable.

“At the time, I knew that this practice was dishonest. I participated in this dishonest practice and I accept responsibility for my role,” Parietti said. “I’m sorry for my conduct.”

The plea, pursuant to a cooperation agreement, was followed on June 2 by the U.S. Justice Department unveiling an indictment against two other former Deutsche Bank traders, Matthew Connolly of New Jersey and Gavin Campbell Black of London.

Both cases followed the earlier guilty plea in October of a former senior trader at Deutsche Bank, Michael Curtler of London. The bank agreed in April 2015 to pay $2.5 billion to resolve related U.S. and U.K. probes. According to charging papers, from 2005 to 2011 Parietti and others engaged in a scheme to manipulate Libor, which was tied to the profitability of derivative trades in which they had a financial interest. In charging Connolly and Black, prosecutors said that at least eight other people, including Curtler, were involved in the scheme to submit false estimates for some Libor rates in order to manipulate it. Connolly has pleaded not guilty. Black’s attorney has previously declined comment.

 

The Problem With Reference Benchmark Rates

A host of factors have put critical financial market benchmark rates such as LIBOR or BBSW under the spotlight. Can we trust them? It has been suggested that some banks have been rate rigging – for example in Australia, ASIC has commenced proceedings against some of our largest banks and there is debate about an alternative and more robust benchmark. So, an interesting speech by FED Governor Jerome H. Powell at the Roundtable on the Interim Report of the Alternative Reference Rates Committee sponsored by the Federal Reserve Board and the Federal Reserve Bank of New York looking at LIBOR is highly relevant.  They just issued an interim report which shows that US Dollar Interest Rate Derivatives account for about US$200 trillion, with more than half in interest rate swaps, so small tweaks to the benchmark rate can yield big profits to the industry.

US-Rate-Derivitives

I want to thank the Alternative Reference Rates Committee (ARRC) for all its work in developing its interim report. This report marks a new stage in reference rate reform.1 Reference benchmarks are a key part of the financial infrastructure. About $300 trillion dollars in contracts reference LIBOR alone. But benchmarks were not given much consideration prior to the recent scandals involving attempts to manipulate them. Since then, the official sector has thought seriously about financial benchmarks, conducting a number of investigations into charges of manipulation, publishing the International Organization of Securities Commission’s (IOSCO) Principles for Financial Benchmarks and, through the Financial Stability Board (FSB), sponsoring major reform efforts of both interest rate and foreign exchange benchmarks.2 The institutions represented on the ARRC have also had to think seriously about these issues as they have developed this interim report. Now, we need end users to begin to think more seriously about how they use benchmarks and the risks they are taking on by relying so heavily on a reference rate–in this case U.S. dollar LIBOR–that is less resilient than it needs to be.

In saying this, I want to make it clear that LIBOR has been significantly improved. ICE Benchmark Administration is in the process of making important changes to its methodology, and submissions to LIBOR are now regulated by the United Kingdom’s Financial Conduct Authority. However, the term money market borrowing by banks that underlies U.S. dollar LIBOR has experienced a secular decline. As a result, the majority of U.S. dollar LIBOR submissions must still rely on expert judgement, and even those submissions that are transaction-based may be based on relatively few actual trades. This calls into question whether LIBOR can ultimately satisfy IOSCO Principle 7 regarding data sufficiency, which requires that a benchmark be based on an active market. That Principle is a particularly important one, as it is difficult to ask banks to submit rates at which they believe they could borrow on a daily basis if they do not actually borrow very often.

That basic fact poses the risk that LIBOR could eventually be forced to stop publication entirely. Ongoing regulatory reforms and changing market structures raise questions about whether the transactions underlying LIBOR will become even scarcer in the future, particularly in periods of stress, and banks might feel little incentive to contribute to U.S. dollar LIBOR panels if transactions become less frequent. Market participants are not used to thinking about this possibility, but benchmarks sometimes come to a halt. The sudden cessation of a benchmark as heavily used as LIBOR would present significant systemic risks. It could entail substantial losses and would create substantial uncertainty, potential legal challenges, and payments disruptions for the market participants that have relied on LIBOR. These disruptions would be even greater if there were no viable alternative to U.S. dollar LIBOR that market participants could quickly move to.

These concerns led the FSB and Financial Stability Oversight Council to call for the promotion of alternatives to LIBOR, and led the Federal Reserve to convene the ARRC in cooperation with the U.S. Treasury Department, U.S. Commodity Futures Trading Commission, and Office of Financial Research. LIBOR is currently the dominant reference rate in the market because of its liquidity. We are not under any illusions that moving a significant portion of trading to an alternative rate will be simple or easy. But I believe the ARRC has provided a workable and credible plan for creating liquidity in a new rate and beginning the process of moving trading to it.

We need input from end users and others to finalize the ARRC’s plans, and I look forward to hearing the views of those in attendance. Successful implementation will require a coordinated effort from a broad set of market participants. This effort will certainly entail costs, but continued reliance on U.S. dollar LIBOR on the current scale could entail much higher costs if unsecured short-term borrowing declines further and submitting banks choose to leave the LIBOR panels, especially if there were no viable alternative rate. Simply put, this effort is something that needs to happen, and if the ARRC members, the official sector, and end users and other market participants all jointly coordinate in finalizing these plans, then a successful transition can be made with the least disruption to the market, leaving everyone in a better place.

1. See Alternative Reference Rates Committee (2016), Interim Report and Consultation (PDF) Leaving the Board (New York: ARRC, May).

2. For more information on the IOSCO principles, see Board of the International Organization of Securities Commissions (2013), Principles for Financial Benchmarks: Final Report (PDF) Leaving the Board (Madrid: IOSCO, July).