"Reforming Major Interest Rate Benchmarks" from the FSB looks at using GCF repo as derivatives benchmark

The Financial Stability Board published on July 22nd a major report “Reforming Major Interest Rate Benchmarks”. They look at how the ‘IBORs could be reformed. The LIBOR scandal may have prompted the work, but it goes beyond that to include “risk-free rate” options available. Repo is part of the mix and we take a look.

From the report, the underlying principals are:

(1) Strengthening existing IBORs and other potential reference rates based on unsecured bank funding costs by underpinning them to the greatest extent possible with transactions data (the MPG calls these enhanced rates “IBOR+”).

(2) Developing alternative, nearly risk-free reference rates. Members believe that there are certain financial transactions, including many derivatives transactions that are better suited to reference rates that are closer to risk-free. Developing such alternative reference rates meets the principle of encouraging market choice.

(The MPG is the ”Market Participants Group”, chaired by Stanford University professor Darrell Duffie.)

The more interesting part of the FSB work is on “risk-free rates”. The report focused on a number of jurisdictions, but for this post we will look at what they had to say about the U.S. The U.S. contributors advocate a multiple-rate benchmark approach, but see risk-free rates dominating.

“…A multiple-rate approach for U.S. dollar reference rates with risk-free rates serving as the dominant benchmark for derivatives and a LIBOR+-like rate serving as the benchmark for credit products has a number of likely benefits…”

Which trades would get risk-free benchmarks and which would still use LIBOR or other credit driven rates?

“…a risk-free rate for derivatives products that are collateralised and a rate with bank credit risk for lending products…”

So does this imply that existing interest rate swaps would substitute LIBOR for something else if they were centrally cleared and hence collateralized? The FSB recognized the difficulty (read: near impossibility) in simply changing the formulas determining derivatives cash flows on existing trades. Reading between the lines, this is really about shifting the market for new trades and not legacy deals.

So which risk-free rates? The MPG had some ideas:

“…the MPG recommended a number of rates for USD that are not based on unsecured bank borrowing in their menu of potential reference rates including overnight index swap rates (OIS), U.S. Treasury rates, an overnight GC repo rate, the rate of interest on excess reserves (IOER), and a reverse repo rate (RRP) from any potential permanent overnight RRP facility for the U.S. dollar…”

“…U.S. Treasury rates (deep and liquid markets that are more difficult to manipulate and likely to remain robust indefinitely), a rate based on secured funding markets (GC repo markets are liquid and deep for overnight and short maturities), or monetary policy rates such as IOER and RRP (administered rates that are free from market manipulation and not subject to risk of changes in market depth). Other rates considered by the MPG, OIS or FFER, currently trade in relatively thin markets, and are further subject to the risk that their underlying market may become even thinner over time…”

The report also mentioned Constant Maturity Treasury (CMT) rates as a possibility. The Treasury and Fed are doing additional research on CMT.

They are also investigating repo benchmarks outside of GC Repo:

“…While one benchmark based on overnight U.S. dollar GC repo rates already exists (the GCF repo rate published by DTCC), the Federal Reserve will also work with other interested agencies and the private sector to consider whether other rates based on overnight GC repo would be useful and to ensure that these rates are capable of meeting the IOSCO Principles…”

We think that IOER and RRP rates are non-starters. As highly managed rates, they add a level of basis risk that creates unnecessary complexity. GCF Repo and OIS are contenders. GCF repo is observable, executable, collateralized as well as being centrally cleared – although markets don’t extend very far out, making it hard to establish forward rates for discounting. One issue with OIS is that is it indexed to the the thinly traded Fed Funds market, but there are long-dated markets. U.S. Treasury rates certainly have liquidity going for them. They may have a leg up based on their use in Treasury floaters.

The timeline to determine the feasibility of GC as reference rate is 2014:Q4. This will be interesting.

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