Ending the use of dollar Libor, the scandal-tinged benchmark bank funding rate, was always going to be problematic. Some Libor traders went to jail for collusion and self-enrichment. The Fed and its fellow regulators put together a public-private committee on Libor replacement big enough to swamp a ferry boat.
That hasn’t entirely worked. The use of Libor as a base rate for funding costs is bigger than ever — around $225tn of derivatives, consumer loans, corporate loans and cash investments. Nevertheless, the use of Libor is supposed to end, mostly, on December 31 for some Libor rates and by mid-2023 for those remaining.
The process of finding practical ways to replace it have led to increasingly audible shouting and blame trading between the major dealing banks and the Fed, along with the central bank’s entourage of agencies, academics, policy wonks and whisperers.
The major point of argument is the Fed’s ambition for the banks to adopt Sofr, a “secured overnight funding rate” intended to represent the cost of very short term borrowing using US government debt as collateral. The mechanics of using Sofr to replace Libor have been the object of fiddling by the officially blessed Alternative Reference Rates Committee since 2014.
As with so many public private partnerships, the ARRC began with grim co-operation and is now an object of revulsion for some key members.
For some, Sofr may have pristine collateral and governance, but does not reflect the real world of trying to price future interest rates and possible credit losses or systemic risk.
Unlike for Libor, there is not currently a Sofr rate for different time periods that would provide an explicit benchmark for borrowing for say, three or six months. In addition, there is not a Sofr rate with collateral based on private sector loans. This is a risk for banks.
For example, as the Bank Policy Institute has pointed out, in times of stress, rates based on Sofr would fall as the traditional haven asset of US Treasuries rallies. At the same time, banks’ costs of funding would rise as short-term credit rates spike. Thus bank lending margins would be squeezed at a difficult moment.
Thomas Pluta, JPMorgan’s global head of linear rates trading, agrees that “yes, [Sofr] creates a lot of credit basis risk. A lot of banks, particularly regional banks, have been vocal about the lack of credit sensitivity. If you are funding yourself in unsecured markets, that is a pretty obvious concern.”
A Sofr futures contract proposed this week by the futures exchange CME addresses some of the problem of the lack of different time terms. But even then it is based on derivatives. Fed economists apparently believe that a set of derivatives contracts would conjure up a liquid cash market for the underlying funding instruments. The bankers do not share this faith. And the CME contract does…
Read More: End of Libor stirs anger on Wall Street