Whoa Mr. Gensler, don’t trash LIBOR just yet – repo futures and OIS are not ready for prime time

As a follow-up to our post last Thursday on the Global Financial Markets Association’s LIBOR conference, we wanted to revisit a topic that CFTC chairman Gary Gensler brought up: that benchmarks should be based on observable rates and not on “the rate at which banks do not lend to each other.” While in theory we agree with Mr. Gensler’s point, in practice our research has shown that the alternatives may not be all they are cracked up to be yet.

According to Mr. Gensler: “Given what we know now, it’s critical that we move to a more robust framework for financial benchmarks, particularly those for short-term, variable interest rates. There are alternatives that market participants are considering that are grounded in real transactions. These include the overnight index swaps rate, benchmark rates based on actual short-term collateralized financings, and benchmarks based on government borrowing rates.”

We did a deep dive on this topic in our August 2012 repo, “Repo Indices, Overnight Index Swaps and Other Alternatives to LIBOR.” Among other findings, we recognized that LIBOR has its shortcomings in both credit risk and not being based on a traded benchmark. Low actual trading volumes don’t help either.

Unfortunately, a lack of confidence in LIBOR do not translate into making repo indices or OIS perfect alternatives just yet. On the positive side, US repo indices volumes continue to have depth; the DTCC shows week of February 28 volumes for repo treasuries at $175 billion. While down from $210 billion in December, this is still pretty good. ICAP’s indices in December had Euro 30 to 70 billion in daily notional.

But as we pointed out in August, it is vital to have an actively traded futures market on these indices to hedge risk in real time, and it remains to be seen whether repo futures will get this traction. NYSE Liffe’s repo futures data show that agency and mortgage repo futures volumes have dropped steadily since Q4 2012 and that treasury repo futures are definitely up but not breaking the sound barrier in how fast they are moving in that direction. We like repo indices and futures, but we aren’t sure that we are ready to fully advocate for their use.

OIS has a different problem. The derivatives market is robust but the volumes of the underlying reference rate — Fed Funds — are low. Readers know the reasons – IOER, low interest rates, market segmentation, etc. The calculation of Fed Funds volume may even now be suspect according to a December 2012 Fed report. A three month OIS futures contract began trading on the CME in 2008 but has gotten little volume; possibly the push to futurize swaps will give it new life. While traders might like OIS, calling it a perfect LIBOR replacement is a stretch.

Mr. Gensler mentioned an IOSCO consultation that will come out shortly and that seeks input on two topics:

“• Prospectively, the consultation suggests that contracts referencing a benchmark would be more resilient if those contracts had embedded in them a contingency plan for when a benchmark may become obsolete.

“• And perhaps more challenging, the consultation asks what to do about existing contracts that reference a benchmark that becomes obsolete, if those contracts don’t have an effective contingency plan.”

We think this is excellent and fully support the work. We are big scenario planners and want to see these issues hammered out. But (and you knew there was a but coming), this doesn’t mean that LIBOR is ready for the dust-heap at all.

While Mr. Gensler has been advocating for repo futures and OIS since at least last August 2012 (in a New York Times op-ed here), our evidence suggests that the market is in for a period of prolonged transition, possibly up to 20 years, as LIBOR gets strengthened and potential alternative benchmarks develop greater depth. We think it is premature to make a call for an entire eradication of LIBOR. Rather, let the British government’s new Hogg Tendering Committee do its work, select a new LIBOR administrator, and see what benchmarks looks like one to two years later. Given the speed of regulation, we don’t think that a LIBOR alternative could be accepted and promulgated any faster.

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