{"id":6373,"date":"2020-06-29T09:38:51","date_gmt":"2020-06-29T09:38:51","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=6373"},"modified":"2021-10-26T04:07:21","modified_gmt":"2021-10-26T04:07:21","slug":"beyond-libor-a-primer-on-the-new-benchmark-rates","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/frm\/part-2\/current-issues-in-financial-markets\/beyond-libor-a-primer-on-the-new-benchmark-rates\/","title":{"rendered":"Beyond LIBOR: a primer on the new benchmark rates"},"content":{"rendered":"<p><strong>After completing this reading you should be able to:<\/strong><\/p>\n<ul>\n<li>Describe the features comprising an ideal benchmark.<\/li>\n<li>Examine the issues that led to the replacement of LIBOR as the reference rate.<\/li>\n<li>Examine the risks inherent in basing risk-free rates (RFR\u2019s) on transactions in the repo market.<\/li>\n<\/ul>\n<h2>LIBOR<\/h2>\n<p>The London Interbank Offered Rate (LIBOR) is the benchmark (reference) interest rate for millions of contracts worth more than USD 350 trillion, ranging from complex financial derivatives to residential mortgages. LIBOR comes in five different currencies, and its maturity ranges from overnight to twelve months.<\/p>\n<p>Although it been referred to as the \u201cworld\u2019s most important number,\u201d LIBOR has had a fair share of opposition. There are reforms to replace LIBOR with new risk-free rates. In 2017, it was announced that panel banks would cease to be persuaded or riveted to submit required rates to calculate LIBOR.<\/p>\n<p>Interbank unsecured term borrowing, which is the basis for LIBOR, has significantly reduced. This only implies that LIBOR may stop playing its central role.<\/p>\n<h2>Features of an Ideal Benchmark<\/h2>\n<p>An ideal benchmark rate is the one that provides standard excellence to the preset objectives. For example, an ideal investment benchmark is a yardstick to guide an investment strategy and to gauge the success of this strategy. It represents a \u201cneutral\u201d position for the investor with matched risk tolerance, investment horizon, liquidity needs, and returns objectives with its investment policy. An ideal benchmark has the following features:<\/p>\n<ol type=\"i\">\n<li><strong>Provides a credible representation of interest rates in the center of money markets: <\/strong> Benchmarks obtained from actual transactions in money markets are the best.<\/li>\n<li><strong>Provides a benchmark rate for finance-related executions:<\/strong> Benchmark rates must be utilizable for different purposes beyond the money market. They can be used even in complex financial transactions such as the issuance of securities with variable rates and swaps. Therefore, the reference rates must reliably reflect a credible market for the interest measured by the benchmark and are held in transactions.<\/li>\n<li><strong>Serves as a benchmark in loans and interest rate derivative contracts:<\/strong> Financial intermediaries such as investment banks are lenders and borrowers. Thus, they need a lending reference that is similar to the rates at which they fund. To obstruct the relative underlying interest rate risk, the lender can dive into a swap as a fixed rate payer. The public authorities can help bring together market participants to help smooth any transition, by encouraging transparency of markets from which reference rates are obtained. Transparency provisions are intended to support users to understand better the features of the benchmark, and of the underlying interest, which should aid their choice.<\/li>\n<\/ol>\n<p>Notably, in the past, market players were steered more by funding costs than the above features.<\/p>\n<h3>Reasons for Replacement of LIBOR<\/h3>\n<p>Although LIBOR provides a reference rate for financial contracts and acts as a benchmark for lending and funding, it can easily be manipulated. Its vulnerability to manipulation is as a result of the following:<\/p>\n<h4>Loss of credibility<\/h4>\n<p>Since LIBOR rates are set by banks submitting their estimates of their borrowing costs, the rates can be maneuvered by those member banks. Additionally, LIBOR is constructed in such a way that it relies on market and transaction data-based expert judgment instead of actual operations. For example, during the financial crisis, large banks manipulated LIBOR by reporting low rates to make the bank look stronger than it is and reporting false rates to profit on LIBOR-based financial products.<\/p>\n<h4>Sparse activity in interbank deposit markets<\/h4>\n<p>Sparse activity in interbank deposit markets is an obstacle to a possible transaction-based benchmark based on interbank rates. Thus, very few actual transactions act as a backbone to the submissions for longer LIBOR tenors. The underlying market that LIBOR seeks to measure\u2014the market for wholesale term lending to banks\u2014is no longer sufficiently active.<\/p>\n<h4>Increased dispersion of individual bank credit risk<\/h4>\n<p>Markets have grown in scale and complexities. The methodology for obtaining LIBOR is outdated since it has remained the same for a long period; thus, making large banks report fewer transactions. Additionally, the sensitivity to liquidity shown by money markets has made banks reduce their term lending to each other and move to non-bank borrowers for unsecured funding; thus, increasing the variation in the money market rates, hence the transition from LIBOR to risk-free rates.<\/p>\n<h4>Regulatory and market efforts to reduce counterparty credit risk<\/h4>\n<p>LIBOR includes a built-in credit-risk component because it represents the average cost of borrowing by a bank. Lenders have turned to funding less risky investments, such as repos. The results of doing away with standardized over-the-counter claims to collateralization of over-the-counter derivatives have increased the significance of funding with little or no credit risk. For this reason, swaps and other derivatives have broadly drifted away from LIBOR.<\/p>\n<h3>Features of New Benchmark Rates<\/h3>\n<p>Rates which have been designed to replace LIBOR in the market must have the following features:<\/p>\n<ol type=\"i\">\n<li><strong>Less risky:<\/strong> The new reference rate must be purely a daily rate (overnight rate). Having short tenors makes the investment less prone to risks.<\/li>\n<li><strong>Move beyond interbank markets: <\/strong>The new reference rates must be reliably utilizable for diverse uses to increase borrowing from non-bank equivalents such as insurance companies.<\/li>\n<li><strong>Make use of secured transactions:<\/strong> The new rates could draw on secured instead of unsecured transactions to aid in controlling the risks which are likely to occur.<\/li>\n<\/ol>\n<h3>Risk-free Rates (RFRs)<\/h3>\n<p>There is no such thing as a riskless financial instrument. Every investment must have a certain probability of occurrence of a risk. When we talk of risk-free rates, we mean that there are virtually zero risks. The investor has little or no interest payments to cushion a fall.<\/p>\n<p>The following table highlights the differences between the RFRs, which will replace LIBOR across various jurisdictions.<\/p>\n<p>$$ \\begin{array}{c|c|c} \\textbf{Jurisdiction} &amp; \\textbf{Alternative RFR} &amp; \\textbf{Key features} \\\\ \\hline \\textbf{US} &amp; {\\text{Secured Overnight} \\\\ \\text{Financing Rate (SOFR)} } &amp; {\\text{Secured} \\\\ \\text{Fully transaction-based} \\\\ \\text{Cleared} } \\\\ \\hline \\textbf{UK} &amp; {\\text{Reformed Sterling} \\\\ \\text{Overnight Index Average} \\\\ \\text{(SONIA)} } &amp; {\\text{Fully transaction-based} \\\\ \\text{Cleared} \\\\ {} } \\\\ \\hline \\textbf{Eurozone} &amp;{\\text{Euro Short-Term Rate} \\\\ \\text{(ESTER)} } &amp; {\\text{Fully transaction-based} \\\\ {} }\\\\ \\hline \\textbf{Switzerland} &amp; {\\text{Swiss Average Rate } \\\\ \\text{Overnight (SARON)} } &amp; {\\text{Secured} \\\\ \\text{Cleared} } \\\\ \\hline \\textbf{Japan} &amp; {\\text{Tokyo Overnight Average } \\\\ \\text{Rate (TONA)} } &amp; {\\text{Fully transaction-based} \\\\ \\text{Cleared} } \\end{array} $$<\/p>\n<p>The risks inherent in basing risk-free rates on transactions wholesale funding include:<\/p>\n<ol type=\"i\">\n<li><strong>Trading at different levels:<\/strong> The risk-free rates based on repo markets are expected to trade at distinct degrees compared to unsecured overnight rates. Secured overnight financing rate (SOFR) has always traded above the level determined by the interest rate on excess reserves (IOER) and the Federal Reserve\u2019s overnight reverse repo facility rate. In the repo market, the SOFR is above the tri-party general collateral (GC) and below the Depository Trust and Clearing Corporation\u2019s (DTCC\u2019s) GCF Treasury repo rate.<\/li>\n<li><strong>The inclusion of borrowing costs:<\/strong> The difference between the new risk-free rates and first rates is the inclusion of borrowing costs for non-banks. The different regulatory costs suggest that borrowing from non-banks is cheaper than equivalent interbank rates. This causes unsteadiness in some of the reformed rates, e.g., the SONIA.<\/li>\n<li><strong>Volatility:<\/strong> Risk-free rates based on the repo markets are expected to trade at different levels compared to the unsecured overnight rates and to be more volatile in some cases. For instance, the SOFR shows volatility due to conditions in collateral markets and dealer balance sheet management.<\/li>\n<li><strong>Manipulation of financial statements: <\/strong>The effective federal funds rate (EFFR) is sensitive to this manipulation. Due to balance sheet window-dressing by non-US banks facing month-end disclosure requirements, the EFFR shows a tendency to drop at month-ends. The non-US banks have a vast presence in the federal funds and Eurodollar markets since they can achieve arbitrage benefits from the interest rates on excess reserves (IOER).<\/li>\n<li><strong>Inflation:<\/strong> This is a common experience in every economy. Assets that are deemed risk-free have a smaller return on investment compared to the risky ones.<\/li>\n<li><strong>Interest rate risk: <\/strong> In many instances, higher inflation is always succeeded by a sequential increase in interest. When interest rates rise, the value of the securities for the debt fall, impairing the sale of a risk-free asset. The sensitivity of risk-free holdings to interest rates makes them have a high-interest rate risk.<\/li>\n<li><strong>Opportunity cost: <\/strong>All financial decisions, even risk-free assets, carry opportunity costs. There are opportunity risks; just in case, the investor gets a better investment elsewhere.<\/li>\n<\/ol>\n\n            <div \n                class=\"elfsight-widget-pricing-table elfsight-widget\" \n                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Examine the issues that led to the replacement of LIBOR as the reference rate. Examine the risks inherent in basing risk-free rates (RFR\u2019s) on&#8230;<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[101],"tags":[],"class_list":["post-6373","post","type-post","status-publish","format-standard","hentry","category-current-issues-in-financial-markets","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.4 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Beyond LIBOR: A Primer on the New Benchmark Rates | AnalystPrep - FRM Part 2 Study Notes<\/title>\n<meta name=\"description\" content=\"The London Interbank Offered Rate (LIBOR) is the benchmark (reference) interest rate for millions of contracts worth more than USD 350 trillion, ranging from complex financial derivatives to residential mortgages. 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