The Wheatley Review on LIBOR released Friday was a strong indictment of LIBOR in its current incarnation but contained well-thought out proposals on where things go from here. The most compelling section of the report was an analysis of other benchmarks, their pros and cons, and whether the market should stick with an improvement LIBOR or look for alternatives. Comments from the report and our analysis follow.
The Review acknowledges LIBOR’s many issues, particularly across 150 different sub-benchmarks with highly varying degrees of liquidity behind them. Chief among these and a point that we have discussed often is LIBOR’s credit risk component: “a single benchmark representing the average credit and liquidity risk of an increasingly diverse set of banks may no longer relate to a given institution’s own borrowing costs. Originally, the credit risk of a panel of leading banks was assumed to be low and relatively homogenous. Where institutions used LIBOR, it was with the understanding that variations in funding costs had a relationship to LIBOR. Now, LIBOR rates have a much more complex credit and liquidity risk elements.” Even a LIBOR that captures non-falsified rates that were based on pretty good underlying transaction volumes (but that wasn’t itself transaction-based) would not avoid this problem entirely. This begets the question, is there something better?
The Review states the five criteria it thinks are necessary to facilitate an alternative benchmark to LIBOR:
1) the benchmark should have a maturity curve for the full spectrum of maturities;
2) the underlying market should be resilient, as far as possible, through periods of stress and illiquidity;
3) a liquid underlying market with transaction volumes would help corroborate the rate;
4) an interest rate benchmark should be transparent, simple and standardised with respect to the instruments and transactions that are used to determine the rate. In particular, across multiple currencies. This can facilitate a deeper and more liquid market from which the rate can be derived; and
5) ideally a historical time series would be available for alternative benchmarks, allowing past behaviour to be used in pricing and risk models.
Unfortunately no perfect beast lives today, although repo could represent an alternative as a longer time series develops. A more nuanced question is are there benchmarks that should be used for different contracts at different times. For example, an interest rate contract may be better off with a GC repo benchmark (even though potential changes to the Fed’s IOER policy could really skew repo rates whenever it happens) as that rate takes out the credit element. OIS might be good too except that liquidity in the Fed Funds market is in terrible shape.
The Wheatley Review has opened the door to a host of new alternatives in the market, but the best thing might be for LIBOR to repair itself. The Review notes the Network Effect of many parties using the same benchmark; there is a strong argument to made for that if reforms can be made in time and there is enough of an underlying market in whatever benchmarks are published to generate a belief in the figures. Otherwise, we see the day that repo indices become a more vital figure.