Reuters published an interesting article yesterday on the European Repo Council, part of the ICMA, meeting with the European Central Bank to discuss “setting up a benchmark based on actual ‘secured market’ trades.” What secured market trades might that be? That’s right, repo. We’ve been keeping a close eye on repo as a LIBOR alternative following the publication of our research report this summer on the matter (“Repo Indices, Overnight Index Swaps and Other Alternatives to LIBOR“). Here’s our take on the latest developments.
Most readers of Finadium reports and articles know the basic problem: LIBOR and other indicative, non-transaction based benchmarks can be manipulated and have credit risk. The world has gotten by with these benchmarks because the implicit trust of the market suggested they were okay, but that time has passed.
The problem however is that an estimated $600 to $800 trillion in financial contracts tie back either directly or indirectly to LIBOR. Not “the new LIBOR.” Not a “repo-like LIBOR alternative.” But LIBOR itself. The paperwork alone to restructure these contracts to a non-LIBOR benchmark would be insurmountable, unless there was a massive multi-government fiat that declared that as far as financial contracts were concerned, LIBOR now meant something else. As a first step, governments would have to agree on what the alternative was. This is all a daunting task. We don’t have figures on the volumes of contracts tied to Euribor but we would expect this to be a healthy number as well.
Most realistically, we will start to see a slow transition to other benchmarks, such as repo indices and futures, until and unless LIBOR, Euribor and others move to more transaction-based models (probably with some level of collateral thrown in that takes out the credit element). Which other benchmarks however is very much subject to debate, and this is where the Reuters story comes in.
Lobbying has begun for each individual benchmark option to take center stage. According to Reuters, “The [European Repo Council] group … asked the ECB to oversee the calculation of the rate, to lend the new index credibility. But the bank’s officials turned down such a role, saying their preference was for such benchmarks to be wholly market-run.” In the US, the DTCC and NYSE Liffe, with their GCF Repo(TM) indices and futures, respectively, would like to take on this benchmark mantle. ICAP wants it too. And the UK’s FSA will soon ask for proposals on taking over LIBOR. This is a horse race.
The story makes note that Euribor-EBF, part of the European Banking Federation, has not been laying about either. According to Reuters citing Cedric Quemener, director at Euribor-EBF: “‘We … are already working on a repo real-transaction-based benchmark,” he said. “We have reached a consensus across European banks in supporting the repo effective project (named Reonia).'”
Financial markets thrive on innovation and we applaud all of these efforts. However, each are still dogged by their own issues, and we believe it will be years to finally sort out which benchmarks work best for which users. The Reuters article cites low LIBOR trading volumes as part of the problem, but this isn’t something that other benchmarks can avoid just because the markets would like them to. According to the story: “The new models to calculate funding, which could take many years to realise, would address another problem in a crisis that shows little sign of abating after half a decade: how to calculate an accurate price for funding when banks are unwilling or unable to lend to their peers.”
While we agree with the calculation part, we don’t agree that other benchmarks automatically have more validity than LIBOR or Euribor (but we do agree that transactions need to occur to truly believe what a benchmark is saying). DTCC’s repo volumes have fallen from highs of $360 billion to $275 billion today, and that is across three different asset classes. The ICMA’s June 2012 repo survey showed total volumes at EUR 5.7 billion, down from EUR 6.2 billion in December 2011. Regulators in Europe, the UK and the US also have their own criteria and interests in benchmarks. LIBOR, Euribor and other non-transactions based indices need work without a doubt, but we expect them to still be around for some time to come through a combination of market need and direct or indirect regulatory encouragement. In the meanwhile, the jockeying for alternatives is underway.
The Reuters article is here.