The US risk-free reference rate should be the repo rate

The Federal Reserve hosted a meeting yesterday of market participants and regulators on reforming the US risk-free reference rate for USD derivatives. We strongly think that this rate should be the single best reference rate for overnight transactions: US Treasury repo. LIBOR, a triangulated best guess by multiple trading desks, has been good but its time is done. Fed Funds and OIS don’t work either.

Here’s the context: according to a press release sent out yesterday by the Fed, “the Federal Reserve is interested in seeing market participants work toward alternative reference rates that are based on risk-free (or nearly risk-free) rates based on a robust and liquid underlying market. The Federal Reserve also intends to consult with a wide group of market participants as it continues this process.” To this end, 15 major banks and 12 regulators (including the Fed) gathered to discuss the matter.

Our opinion is that the only credible market reference rate or benchmark is one that has multiple and transparently observed points of input. The S&P 500 and FTSE 100 work well for our purposes. LIBOR doesn’t work. OIS is good but is based off of the discredited Federal Funds rate, which itself has anywhere of 30% to 70% the volume of daily transactions as the Fed’s Reverse Repo Facility, and a paltry 2%-3% of the total estimated US repo market size.

Moving into more details, if you ask to use the US repo rate as the reference rate, which repo rate would apply? Would it be the Reverse Repo Rate which is set by the Fed (and still would have to be made permanent)? How about the FICC’s GCF Repo(R) rate, which is hovering double the Reverse Repo Rate? How about a blended rate of all GCF, Reverse Repo and privately reported transactions? (For more on the depth of privately reported transactions that will soon be available, see our article, “The FSB on securities finance data collection and aggregation: a good start but there are some tough points to resolve“.)

Another counterargument or need for clarification is how easily publicly traded repo might be moved by market technicals, influenced by the bank balance sheet regulation du jour, or impacted itself by the Reverse Repo Facility. Could UST repo futures on the GCF Repo(R) Index have a better promise than the underlying repo rate? Maybe if they had the volumes. NYSE Liffe used to publish GCF Repo(R) Index Futures volume data to the general public, but some time after the ICE acquisition they only publish rate data. We’d like to see more there. Maybe in a year’s time we will be talking about the implied rate out of Single Treasury Futures?

We are interested to learn the outcome of the Fed’s meeting today; we think the most probable outcome is a move away from LIBOR and towards something with observed transactions. Either way, we agree with Fed Board Member Jerome Powell: “Reference rates are one of the foundations of the financial system. Certainly, it is in the interest of everyone, from the residential mortgage holder to the financial institutions that heavily use these rates, that they have integrity and be well constructed and resistant to manipulation.”

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