Key Fed Figure Says Reference Rate Reform a Work in Progress

Michael Volpe

After spending a decade in finance, Michael Volpe has been a freelance investigative journalist since 2009. His work has been published locally in the Chicago Reader, Chicago Crusader, Chicago Heights Patch, and New City. Nationally, Volpe's work has appeared in a wide variety of publications including the Washington Examiner, the Daily Caller, Crime Magazine, the Southern Christian Leadership Conference Newsletter, and Counter Punch. Volpe has been recognized by whistleblowers as leading the charge in getting their stories out. His first book Prosecutors Gone Wild was published in October 2012, his second book The Definitive Dossier of PTSD in Whistleblowers was published in February 2013 and his third book Bullied to Death was published in August 2015.

Federal Reserve Bank of New York

Key Fed Figure Says Reference Rate Reform a Work in Progress

May 25, 2018
William C. Dudley President of Federal Reserve Bank of New York
William C. Dudley President of Federal Reserve Bank of New York

A key Federal Reserve official said reference rate reform remains a work in progress.

William Dudley is the President of the Federal Reserve branch in New York and he made the remarks in a speech at the Bank of England.

“In short, I will argue that while much has already been accomplished, we still have a lot more to do—and it must happen within a compressed time frame.  This is an important point that Andrew Bailey usefully underscored for us last year.  Because of the great uncertainty over LIBOR’s future and the risks to financial stability that would likely accompany a disorderly transition to alternative reference rates, we need aggressive action to move to a more durable and resilient benchmark regime.”

A reference rate “is an interest rate benchmark used to set other interest rates. Various types of transactions use different reference rate benchmarks, but the most common are the LIBOR, the prime rate, and benchmark U.S. Treasury securities. Reference rates are useful in homeowner mortgages and sophisticated interest rate swap transactions made by institutions.” According to the website, Investopedia.

Dudley went on to note that LIBOR itself may have caused the need for reform.

“At its core, the problem we face today is that the financial system has built a tremendously large edifice on a structurally impaired foundation.  While many in the industry cannot recall a time when LIBOR did not exist, in fact, it was only developed in the 1980s.  Since then, the use of LIBOR as a reference rate has exploded—with the size of financial contracts referencing U.S.-dollar LIBOR today estimated at close to $200 trillion.The vast majority of these exposures are derivative obligations, such as interest rate swaps.  But, that tally also includes trillions of dollars of cash products, such as residential and commercial mortgages, corporate bonds and loans, and securitized products.  And, with new contracts referencing LIBOR still being written, this balance continues to grow significantly.

“Broadly speaking, reference rates are vital to efficient market functioning.  They facilitate trading in standardized contracts, which lowers transaction costs and increases market liquidity.  Robust reference rates can also reduce information asymmetries and the risk of misconduct by providing transparent, independent pricing.”

LIBOR went through a scandal where traders at Europe’s biggest banks were using secret chatrooms to telegraph trades to each other, but Dudley believes the problem were far greater that the scandal: “But, in the case of LIBOR, the foundation had serious flaws.  Most notably, LIBOR was (and is) based on submissions from individual banks—which, in turn, were based on hypothetical borrowing rates or expert judgments, and not actual transactions.

“Moreover, deficiencies existed in regulatory oversight and governance of the rate-setting mechanism.  These vulnerabilities enabled the manipulation of the rate for the financial benefit of individuals and institutions.  Amid profound breakdowns in controls and compliance, individual traders conspired with rate submitters at their own institutions or traders at other firms to manipulate the setting of the rate to improve their trading results.  During the global financial crisis, panel banks also reportedly submitted lower borrowing rates than they could actually obtain in the marketplace.  They did so to disguise their financial fragility at a time when uncertainty over bank liquidity and solvency was high.”

Dudley noted that in the last half decade global regulators and central bankers have responded by developing alternative reference rates.

IOSCO“In recent years, international and domestic authorities alike have actively worked with the private sector to address LIBOR’s shortcomings and to find alternative rates.  One notable development has been the publication of an international set of principles for financial benchmarks, developed by the International Organization of Securities Commissions (IOSCO) in 2013.13   These principles—which include 19 specific standards across governance, benchmark quality, methodology, and accountability—have emerged as the international standard.  IOSCO has rightly focused on tying benchmarks more closely to observable, arms-length transactions. This represents an important step toward eliminating excessive reliance on expert judgment.”

Also, Dudley noted that in the US the Alternative Reference Rates Committee (ARRC) was formed to develop an alternative reference rate.

This turned into his Federal Reserve Bank of New York which recently launching the Secured Overnight Financing Rate (SOFR): “The ARRC has made important progress in achieving its mandate.  Notably, in June 2017, it selected the Secured Overnight Financing Rate, or SOFR, as its preferred alternative to U.S.-dollar LIBOR.  SOFR is a broad measure of the cost of borrowing cash overnight using U.S. Treasury securities as collateral and is thus relevant to a wide range of market participants.  The rate is entirely transaction-based, and the underlying market is robust, with current daily volume of more than $700 billion.  (By comparison, unsecured three-month U.S.-dollar wholesale borrowing totals roughly $1 billion per day, as I mentioned earlier.)  SOFR moves closely with LIBOR and other money market rates over time, and because it covers multiple segments of the repo market, it provides scope for future market evolution.   Besides being more resistant to manipulation, this nearly risk-free rate should also prove much more resilient during periods of financial stress, because the U.S. Treasury repo market is likely to remain deep and active during such episodes.”

SOFR has already had a direct effect on the trading world.

The CME quickly announced trading of SOFR futures, shortly after the rate was launched on April 3, 2018.

“SOFR futures trade alongside highly liquid Eurodollar, Fed Fund and Treasury futures to offer enhanced spread trading capabilities via CME Globexintercommodity spreads and capital efficiencies through margin offsets.” The CME noted in promoting the futures product on its site.

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