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The Benchmark Set to Replace Libor Is Acting Weird

Recent volatility in the market for overnight cash loans is raising concerns about a new benchmark that could set interest rates for trillions of dollars in mortgages and corporate debt.

The cost to borrow cash overnight spiked late last year in part of the market for repurchase agreements, where lenders such as money-market funds make short-term loans to bond brokers, often using government debt as collateral. The “repo” rate topped out above 6% in intraday trading on Dec. 31 before settling at an all-time high of 5.149%, according to JPMorgan.

That has investors and bankers paying close attention to developments in this obscure yet vital part of the debt market, because repo trades are a key component of a new borrowing benchmark designed by the Federal Reserve Bank of New York. That benchmark, called SOFR, for the secured overnight financing rate, is considered the leading candidate to replace the fading London interbank offered rate, currently used in setting interest rates on hundreds of trillions in debt.

On Dec. 31, SOFR jumped from 2.46% the day before to 3%, at the time the highest level since the Federal Reserve began publishing the benchmark last April.

Libor for many years was closely watched as a benchmark for lending and as a measure of stress in the banking system. Its surge versus other borrowing rates in late 2008 spurred investors’ fears as the financial crisis accelerated.

But it was discredited after evidence emerged that bank traders were manipulating Libor in order to make trading profits. Banks were fined billions of dollars, and several traders were sent to prison. Since 2012, Libor has been under the supervision of U.K. regulators and is expected to expire at the end of 2021.

If SOFR proves unusually volatile or hard to predict, it would diminish the benchmark’s appeal to companies that are considering tying their borrowing costs to it, adding uncertainty to the market’s search for a suitable Libor alternative.

The supply of securities that are used for collateral in the repo market has grown as the Treasury has increased its sales of short-term debt to help fund rising budget deficits. At the same time, demand for the securities has increased after the banking industry’s central clearinghouse for bonds, the Fixed Income Clearing Corp., began allowing banks to sponsor hedge funds as direct participants in repo trading.

The repo market “is absolutely an indispensable grease and catalyst to the smooth functioning of other markets,” said Glenn Havlicek, a former banker who is now chief executive of GLMX, a technology company that is providing tools to repo trading firms, with the aim of making it easier to transact and report pricing. “But it was never anticipated for prime time. There are definitely growing pains.”

Volatility in the repo market could pose problems for the banks and investment firms that have united to support the adoption of SOFR as a replacement for Libor.

The three-month dollar Libor rate, the most widely used variable-rate benchmark, which is used in financial contracts valued at roughly $200 trillion, according to the Fed, is based on an estimate of what banks would pay to borrow for that period, and is set at the time of the loan, resetting every three months.

The three-month SOFR rate is calculated using overnight yields during the period, so the rate isn’t known until the cumulative yields have been compounded. This method exposes borrowers and lenders using SOFR to market volatility, as yields in the repo market can move along with the yields on short-term Treasurys.

Repurchase agreements typically are subject to rises in volatility at the ends of months, quarters and years or at other periods where cash is in demand. Some analysts expect volatility to rise toward the end of this month, when the U.S. debt ceiling could limit the Treasury’s ability to sell short-term bills.

That volatility could make it more difficult for borrowers to use a benchmark subject to unexpected spikes depending on supply and demand within the cash market. The repo market has seen trading volume grow, often rising above $1 trillion a day from about $800 billion a year ago.

Libor has experienced some atypical volatility, as well. On Thursday, the three-month interbank rate had its biggest one-day decline since 2009, and analysts had no clear reason to explain the move.

Banks’ unwillingness to add to their year-end positions by borrowing securities on Dec. 31 may have contributed to a sudden doubling in the repo rate on that day, analysts said.

Part of the largest banks’ regulatory capital requirements are determined by a snapshot of their holdings on the last day of the year. As a result, a tiny change in their books could tip them into a much higher or lower capital-requirement tier for the entire next year.

“Some banks likely pulled back from the repo market in order to avoid triggering a higher surcharge and the need to hold additional capital in 2019,” Bank of America Merrill Lynch strategists wrote in a January note.
Source: Dow Jones

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