By Marshall Auerback, a market analyst and Research Associate at the Levy Institute. Originally published at the Independent Media Institute
Central banking systems like the Federal Reserve set interest rates that the public ultimately pays on its debt, loans and mortgages. They raise or lower short-term rates, stipulating bank reserve requirements, and establish a “floor” by paying interest on those reserves held in the banking system. That process describes interest rate setting in a national context.
But as we know, finance is now global, capital controls continue to diminish and dollar lending takes place in practically every major financial jurisdiction on the planet. As dollar funding became globalized, there grew a desire for an international benchmark, out of which evolved the London Interbank Offered Rate (LIBOR), a lynchpin that has been used as the reference point for everything from credit card rates to student loans, mortgages, and international borrowing, especially for the multitrillion-dollar interest rate derivative contracts.
Of course, as we now know, there was nothing “market-based” in the setting of the LIBOR. In fact, the bankers and related institutional investors engaged in sustained efforts to manipulate the rate to benefit the profitability of their own institutions, literally costing borrowers hundreds of billions of dollars in fees as a consequence of this collusive behavior.
The main banks involved in setting these artificially derived rates were a cartel, which conspired to manipulate LIBOR and not only lied about it but also covered up the cartel and the fraud scheme that was used. This game became exposed in the aftermath of the 2008 financial crisis when the U.S. Department of Justice, the UK’s Serious Fraud Office, and a host of other global regulatory bodies began to scrutinize more closely the practices of the global banking behemoths, such as UBS, HSBC and Citigroup.
So it may come as some surprise to many that LIBOR is still the benchmark for this multiplicity of functions, even as many of the bankers and investors responsible for its manipulation have gone to jail or have faced huge penalties, some of the largest from the overall $320 billion in misconduct fines since the financial crisis. Many of the world’s large financial institutions are signed on with LIBOR until 2021, at which point they may turn to the Secured Overnight Financing Rate (SOFR), which is now being published by the New York Federal Reserve, as the first in a series of steps to enable a transition from LIBOR.
Given the existing taint of criminality, replacing LIBOR makes sense. What is harder to justify is that many of the very same institutions found complicit in the LIBOR manipulation scandal are the main players being tasked to find and market its replacement. This has been a pretty standard modus operandus when it comes to implementing changes in the wake of the 2008 crash, namely deferring to the interests/preferences of Big Finance. Virtually no inputs are coming from the parties adversely affected by the scandal, nor from policy-makers, regulators or academics with a credible track record of genuine financial reform. The justification being offered is that the banks are now subject to far greater regulatory scrutiny than was the case before the scandal was uncovered (that’s doubtful given the U.S. Justice Department’s questionable claim that imposing criminal charges on the offending banks—as opposed to individual bankers—would endanger financial stability, as well as the fact that the Trump administration seems hellbent on rolling back any form of financial regulation).
The other claim made in favor of retaining LIBOR for now is that to drop it immediately in the absence of a viable, liquid alternative would bring considerable costs and risks for financial firms on the grounds that any new benchmark would require changes to the banks’ “value at risk” models, valuation tools, product design and hedging strategies. That may be more justifiable, but as Yves Smith, publisher of the economics blog Naked Capitalism, cautions, “a widespread failing in the United States is the degree to which banking authorities treat their charges with undue deference,” which means that the regulators should take the banks’ recommendations with a grain of salt, given the level of self-interest and historic self-dealing.
Nevertheless, in light of LIBOR’s loss of credibility as a benchmark rate due to attempted market manipulation, false reporting of global reference rates and the decline in liquidity of interbank unsecured funding markets, any move from LIBOR is to be welcomed. With that in mind, the Financial Stability Board (FSB) has been rightly tasked by the G20 to review the major interest rate benchmarks and plan their reforms accordingly.
As noted earlier, the most notable alternative is one being championed by the NY Fed, in combination with group of large banks, the Alternative Reference Rate Committee (ARRC). They have proposed an alternative rate, the Secured Overnight Financing Rate (SOFR). SOFR would be based on transactions in the Treasury repurchase market (in finance-speak, the so-called “repo rate”), whereby banks and investors borrow or loan Treasuries overnight, thus according a central role to the Federal Reserve, instead of a global cartel of 16 international banks from a variety of national jurisdictions. SOFR futures on the Chicago Mercantile Exchange are now being offered (to enhance its liquidity), but challenges remain, notably the paucity of trading infrastructure, development of liquid term structure from an overnight rate, educating stakeholders, hedge accounting eligibility, and legacy LIBOR portfolios.
There is also some suspicion that political considerations are behind the NY Fed’s new proposal, insofar as SOFR, the American-based alternative, is in part seen as preserving dollar hegemony, in part exploiting London’s potential weakness as a future global financial center as a consequence of Brexit and the corresponding fallout with the European Union.
However high-minded or self-interested the proposed reforms might appear to be, the fact is that what the NY Fed is proposing is no longer the London Interbank Overnight Rate, but an alternative American-dollar-based rate.
The dollar is the global currency, goes the implicit argument. So why not have the central bank issuer be in the business of setting a global overnight rate? The champions of this proposal would no doubt suggest that SOFR would mark yet another stage of maturity of central banks working in concert increasingly leading to one global financial mechanism, especially given that the vast bulk of international lending is still dollar-denominated.
Whether they choose to acknowledge this explicitly or not, from the Fed’s perspective, it effectively entrenches them as the global central banker. Under the current system, foreign central banks generally intermediate on dollar transactions on behalf of their individual nations (hold some dollar reserves or treasuries for that purpose), whereas the Fed has historically acted as lender of last resort to its foreign counterparts, one stage removed from the specific commercial transactions at hand. That changes under SOFR, which is directly tied to Treasury repo transactions.
There are other reform proposals. Reuters reports that “a British committee last year selected SONIA, an unsecured overnight lending rate, as an alternative to sterling-based Libor and Japan selected TONAR as an alternative to yen Libor, also an unsecured rate. A group in Switzerland selected SARON, a collateralized rate based on the Swiss repo market.” (Fans of The Lord of the Rings will no doubt appreciate the irony of the Swiss acronym.)
These alternatives might well have a role to play in some limited way, but why would dollar borrowers wish to use sterling, yen or Swiss franc based repo rate, rather than a dollar-sourced funding reference rate?
Additionally, what these counterproposals conveniently ignore is that there is no longer a reason for multiple global centers of dollar lending. It is worth recalling that LIBOR is in fact an offspring of the euro-dollar market, which emerged in London as a consequence of the combined impositions of Regulation Q and the interest-rate equalization tax in the U.S., both of which had the effect of limiting the rates that could be paid to onshore dollar depositors, whether domestic or foreign (primarily in order to protect the great number of small U.S. banks that constituted the American banking system), resulting in a migration of dollar lending to London, which had less onerous restrictions and costs. The 2010 passing of the Dodd-Frank Bill in the U.S. effectively repealed Regulation Q and has therefore allowed for banks to offer interest on checking accounts for its business banking customers globally.
In that sense, LIBOR is now an orphan. Its parentage has been legislated out of existence and the “offspring” of Regulation Q have been shown to have behaved abominably. And the competing international alternatives won’t work, to the extent that these global financial transactions are dollar denominated (as opposed to Swiss franc, yen, yuan, or sterling-based transactions, for which there might be a role, for the other proposals, albeit considerably smaller). To the extent that any of these other financial centers wishes to encourage alternatives to dollar lending, they must be willing to provide substantially greater opportunities to net save in a foreign currency, which means running up persistent current account deficits so that foreigners can more easily accumulate, say, additional euros, francs, yen or sterling. That kind of practice remains anathema to the likes of mercantilist countries such as Germany or China, which creates hurdles to opposing dollar hegemony straight off the bat.
The broader problem in regard to replacing LIBOR is that it starts from the presumption that the broader financial architecture in which it (and its proposed successor, SOFR) exists and operates is sustainable and not in need of substantial repair. The groups consulted on this matter are exclusively the mega-financial institutions (which are generally multiples of national GDP), which were the architects of the 2008 crisis. Nowhere are the consumers of such products being asked for input, even though such entities were the main casualties of the bankers’ malfeasance.
In effect, the inmates are being asked to run the asylum or, at the very least, set up the rules for the central bankers, who may still be too prone to regulatory capture. They are being asked to establish a benchmark for trillions of dollars of complex and relatively opaque derivatives, which, as the LIBOR experience has illustrated, can be used to mask market manipulation, customer deception and outright fraud. Greater efforts should be made to ensure that banks serve their original role as promoter of the capital development of the economy, of which the replacement of LIBOR with SOFR (or some other benchmark) should be but a feature, not a central focus of broader financial reform.
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Could it be that as there is a movement to get out of the dollar trade by some countries, due to the US use of extraterritorial laws, that this is an effort to consolidate the US control of the dollar? I am sure that those countries that use the Euro would be looking askew at this new development too. Already the US has organizations located in it like the World bank, the International Monetary Fund and the International Bank for Reconstruction and Development so this latest development would not be very welcome.
I would imagine that if this goes ahead, that the London Interbank Overnight Rate (LIBOR) would be replaced with one based out of New York which would then be called the New York Interbank Overnight Rate (NYIOR) which would be rather unfortunate. Why unfortunate? Say NYIOR a coupla times out aloud and you may get the idea.
A few comments:
– LIBOR, unlike the article suggest is NOT a USD rate only. LIBOR is a set of rates, for a wide range of currencies (pretty much all majors), where the set of banks on the relevant currency panel was different. LIBOR though is pretty much the only widely used rate for commercial contracts in USD (FedFunds is used as another reference rate, but usually not for commercial contracts). For example, EUR has both EUR LIBOR and EURIBOR.
– LIBOR is unsecured rate, which has advantages and disadvantages. While I’d say that in the current world, where it’s recognised that not all cpties are the same, unsecured rate is more opaque, there is a problem with secured rates. That is, a commercial reference rate should be, ultimately, close to the bank’s funding rate. For a secured funding rate to work, sufficient supply of the collateral must be available, which for USD pretty much means treasuries. With the “we’re issuing too much debt!” Republicans, the bank lending can be fragile with a secured reference rate. There are also potential problems for cross-currency swaps if one rate is secured and one unsecured (although these are not insurmountable, but make their pricing even less transparent than it currently is).
– Aussie banks have a bit more reasonable (=bit more transparent) system, where the AUD rate is so called BBR – Bank Bill Rate. Aussie banks issue a lot of short-term unsecured bills (30/90 etc. days), and the BBR is the day’s average as seen in the market. This model doesn’t work well unless the market already exists though.
A question is, whether most of the commercial users actually need a reference rate, as in my experience they prefer to have fixed rate contracts (unless they have floating rate assets, which is uncommon). Currently, most of the commercial loans are floating, promptly hedged to fixed (often it’s a requirement to hedge!). I believe this is because it’s easier for the banks to make more money on the hedge, for a number of reasons.
Sounds like you know a lot about the subject so I will ask you a naive question on my part. Would it not be possible for every major bank on the planet to post their interest rate to a site for public display, and then have them all added up and divided by the number of banks to gave an average rate and maybe a mean rate as well? You would reckon that with all this you beaut technology that we have it would be relatively simple to do.
That, in theory, was how it worked before, except that you had a panel of the ‘significant’ banks. There’s little point of a bank that does 1mln USD/day posting their rate..
It’s also a rate of what. In theory LIBOR was “Offer Rate”, i.e. the rate the banks were technically offering lending at. In principle, it was never clear what amounts, if any, they were committing to this and for how long. Which again allowed people to cheat (and why Aussie system where actualy trades are monitored is better).
On the technical side, banks will make tons of noises of how they would be losing money to competitors if they were to made their quotes public etc.. But in reality, it’s guaranteeing the quality of the quote that is a much larger problems.
In theory, you could have a systems where all banks (of a certain size) would be required to put a an offer to lend, say 1bln min ticket, any other bank could put in a bid, and at certain time it would – or would not, clear. That would be a better system, as you’d guarantee some quote and liquidity, and you’d also spec the reference rate better (say as as weighted average of what cleared, or lowest offer if it didn’t etc.). You’d still be hard pressed to prevent some sort of colaboration though, if the banks wished to.
Thanks for that reply. It sounds like it is possible but that the ones who would have to implement it would be precisely the ones that would want to game it.
In an Aussie system, would it not still be possible for banks to game the system, though? Issue short-term bills at rates that, while they may not make sense immediately for the bank, will ultimately manipulate the rate to fit their longer-term goals?
Banks, on average, have a credit rating of approximately AA (where AAA is the highest rating). This means there is a credit risk premium built into bank rates.
During October 2008 the premium on eurodollars (unsecured bank lending) peaked at over 450 basis points above 3-month US Treasuries. Such an extreme premium, and its extreme volatility, practically preclude using an unsecured lending rate as a reference. It’s too squirrely.
The main reason behind SOFR (Secured Overnight Financing Rate) is that repos are a vastly larger market than overnight interbank lending, which as we saw during the 2008 can almost disappear when grown-up banksters take fright and distrust their
co-conspiratorspeers.No reference rate is perfect since the counterparties in a repo transaction present credit risk too, but there is an offsetting aspect to their risk compared to the unilateral risk of unsecured lending whose risk premium can go haywire, woefully disrupting the beautiful math of derivatives.
Actually, that may be true for US regional banks (maybe, I don’t know), but a lot of major banks around the world have lower ratings (in US JPM is AA- by Fitch, A- S&P, Citi, GS are A+, WF is A+/A-, etc. etc., a lot of other banks are around A ratings).
That’s to an extent fairly misleading though, as ultimately it’s either their govt rating (by the implicit guarantee), or the rating is pretty much meaningless as’s not a good leading indicator. CDS spreads, which are a better indicator, are for banks all over the place.
You are correct to draw attention to the unsecured nature of the LIBOR rate vs SOFR, which is predicated on secured lending. In that sense, I agree that it is a superior alternative, although those who complain about the dollar’s “exorbitant privilege” (many of the people behind the creation of the euro, for example, had this idea), must tease out the full implications of what the adoption of SOFR actually means. And that’s what I tried to do here.
The Australian system is another good alternative.
Nothing prevents the eurozone, Japan and China from adopting their own SOFR rates based on local sovereign collateral, just as they have done for unsecured lending (e.g. SHIBOR, the Shanghai Interbank Offered Rate).
A change in reference rates likely is a non-event in the longer-term question of how long the dollar’s exorbitant privilege can endure. Whereas the blizzard of US sanctions making the US dollar untenable for use by ostracized countries such as Iran is a strong driver for development of non-USD settlement systems.
Indeed. In fact, an equivalent secured rate would more or less have to come up in all major markets – if noting else, XCY swaps (which are quite common for large corporates) would have to reset off something vaguely comparable.
My major problem with the secured bit is that for it to work well, you have to have a good supply of collateral. Which can be a problem, especially if you get a government that’s obsessed with debt and say stamps down on issuance of short term bills/USTs (or whatever would be the equivalent for a given ccy). TBH, that is really the way this could be controlled much more than the actual repos.
Lots of links in the piece. I could have used a link to, “…many of the bankers and investors responsible for its manipulation have gone to jail…”
This was a distinct bit of the international financial fraud mosaic. So, who exactly, went to jail?
“A few former traders have gone to prison, including Tom Hayes, a former UBS and Citigroup trader who is serving an 11-year sentence in England.”
https://www.nytimes.com/2018/07/19/business/libor-future-2021-phase-out.html
Thank you for this post. I’m not as fearful of SOFR as I was in the first post about this. In fact, I think it’s not a bad idea to use US treasuries as the collateral – essentially. That is a concession in the right direction because money is sovereign and political. The crossover between political and special interest will always be there in a free market, however. The fact that SOFR is not only based on treasuries but an entire derivative market of treasuries is a pretty interesting way to achieve “security” – but why not? It makes more cohesive sense than unsecured speculation. By a long shot. I’m still wondering, however, how this will effect the rule (proposed rule?) that big trading banks must be domiciled in a tax base large enough to bail them out. It’s an ancient fight between mercantilists and free traders – because if you can’t control your banksters with your sovereign banking laws why should you be expected to bail them out? Just curious.
The tell is Who is controlling the conversation and limiting input from outside the cartel. But before matters spiral out of control politically, it might be wise to consider a somewhat more inclusive conversation, perhaps even a new Bretton Woods conference that revisits Keynes’ bancor proposal. After all it’s been a while, and the underlying dynamics have changed a bit since Dex White rode the pony “Dollar Hegemony” across the finish line.
Given subsequent events that include LIBOR rigging, and sovereign defaults with austerity cookie crumbs tracing back to the structures and policies that were established there, who sets interest rates and how they set them seems a rather important consideration to me. I suspect others are also not unmindful of the observation attributed to Mayer Amschel Rothschild, “Give me control of a nation’s money and I care not who makes its laws.”
Just thinking about potential second and third derivatives. Trust once lost is difficult to regain. The Fed’s track record hasn’t been exactly sterling, not to mention the behavior of others who are providing input here.
On a related note: https://www.cnbc.com/2018/07/19/trump-lays-into-the-fed-says-hes-not-thrilled-about-interest-rate-.html . Shots across the bow of the Fed Reserve?
Have to imagine Trump knows that when the Fed Reserve inverts the yield curve, it’s the writing on the wall for a recession. But then Trump doesn’t speak to this (likely doesn’t want the average joe to understand that). Instead he expresses his concern over how higher Fed rates makes the dollar stronger compared to other currencies. Just have to assume he’s using that as the putative issue instead of what the real issue is.
Anyways, can you imagine what conversations are going to be like between WH and Fed Reserve? “Trump: Why are you raising rates?” “Powell: Umm, inflation?”