Finadium has released a new report today, Repo Indices, Overnight Index Swaps and Other Alternatives to LIBOR. The LIBOR scandal has been the tipping point for a change in short term interest rate benchmarks. But false submissions are just the start: the weaknesses in LIBOR go far beyond the current scandal and extend to its vulnerability as a carrier of counterparty credit risk. Mixing credit and interest rate risk in an unpredictable way is asking for trouble, but weaning the LIBOR benchmark of off $800 trillion in derivatives, loans, and mortgages is a daunting task.
After LIBOR, what are the alternatives for a reliable, global financial benchmark? Fed Funds and its derivative Overnight Index Swaps (OIS) are two options. However, Fed Funds and OIS rely on a robust underlying Federal Funds loan market, and decisive policy actions by US regulators have greatly diminished recent loan volumes.
The alternative with promise is repo, and specifically repo on “safe assets” like US Treasuries, Agencies, and Mortgage-Backed Securities. But the repo business has traditionally been opaque and not without its issues in the financial crisis. It is also part of the Shadow Banking investigations currently underway by the Financial Stability Board. New repo indices created by the DTCC go some ways to address transparency issues, but indices alone will not create a new benchmark; a robust futures and derivatives market must also be part of the solution.
In the new report, Finadium evaluates the mechanics and difficulties of LIBOR, and assesses Fed Funds, OIS and repo indices as possible substitutes for LIBOR in financial markets. Ultimately, the markets will turn to the secured collateral of repo as the solution, although there are multiple hurdles that need to be overcome.
This report should be read by traders, institutional investors, policy makers and market intermediaries to gain a robust understanding of how alternatives to LIBOR will affect their daily activities.