Working with the Federal Reserve Bank, a group of 15 global banks and clearing houses called the Alternative Reference Rates Committee (ARRC) has identified two strong alternatives for LIBOR in the U.S. markets. Here’s why alternatives are needed, and a look at some of the benefits they offer.
The Demand For Change
The London Interbank Offered Rate (LIBOR) is a de facto standard rate across the globe. Along with being the benchmark rate for entire Europe, LIBOR is also the reference rate for the $350-trillion global credit market, including $160 trillion worth of U.S. loans market. However, the LIBOR rate rigging scandal exposed the vulnerabilities of having dependencies on a single benchmark rate. While major global banks have paid massive penalties for that scandal, the demand for alternatives has gained momentum amid growing regulatory concerns. (For more, see: How Were Bonds and Derivatives Manipulated in the LIBOR Scandal of 2012?)
The Benefits of Alternatives
The two alternatives identified to replace LIBOR are first, the Fed's Overnight Bank Funding Rate (OBFR), and second, the overnight repo rate used for U.S. Treasuries transactions. Both have a strong market, with each amounting to daily transactions worth $300-billion.
An alternative benchmark rate will add to the stability of the financial system as the existing standard LIBOR rate has a near monopoly. In the presence of strong alternatives, the financial system won’t collapse in case of any serious challenges or malpractices, like the LIBOR rate rigging scandal.
Once the alternatives are finalized, the existing LIBOR-based trades will be allowed in parallel to the transactions based on the new benchmark rates during a defined transition period. This will enable a smooth transition to alternative rates without major disruptions, and wider acceptance by all involved entities.
The Bottom Line
The U.S. is not alone in attempting to identify alternatives, as other nations including Britain, Japan, Switzerland and the combined Euro Zone are also working to find alternative benchmarks. The more benchmarks exist in a system, the more it is shielded from dependencies and challenges associated with the single parameter. While it may take time for new benchmarks to be finalized and get adapted in the system, it will be a win-win situation in the long run for all stakeholders.