What The Fed Meeting With Banks Today Tells Us About Brexit

| About: iShares Russell (IWM)

Summary

Fed Governor Jerome Powell, who is tough on banks, meets with banks today to collaborate.

They are discussing the need to have an alternative to LIBOR.

The discussion reminds us that the financial system is ever connected and fragile.

The Alternative Reference Rates Committee (ARRC) meets today at 2:30 PM. The meeting is with the Fed and many banks and exchanges to discuss a way to create a new rate system that can sidestep LIBOR (We list the participants at the end of this report).

Although this meeting is not focused on the upcoming vote in the UK, we think this meeting is a timely reminder to understand the importance of the UK financial system to the world. Either outcome of Brexit could swing the stock market (NYSEARCA:SPY) based on the amount of global financial players that are involved.

LIBOR liquidity risk

In their interum report the ARRC said they have, "recognized that the secular decline in wholesale unsecured short-term funding by banks poses serious structural risks for unsecured benchmarks such as LIBOR, Euribor, and TIBOR."

Liquidity and supply that determine global interest rates through LIBOR have gone down which has opened the market to "rigging." For today's exercise we are not focused on rigging, but rather, how many global players are intimately involved through the UK, the banking system, and how far the web spreads.

The simple fact that the Fed and banks are in progressive discussions to avoid LIBOR in a much bigger way shows the risks involved. LIBOR, although it is the global standard rate determining infrastructure, has seen its liquidity decline which opens the system to volatility and risk.

Global Financial Players Care

The world runs in some form on LIBOR. Rates, buy and sell decisions, change in principle amounts ultimately help decide LIBOR. The lack of liquidity, according to ARRC makes it a risk. The amount of capital that may change hands on a vote this week either way could cause strain on a less liquid system.

Here's what ARRC said, "As it is well understood, without sustainable trading volume and liquidity, price discovery in unsecured short-term markets will remain uncertain, thus affecting the credibility and reliability of the benchmarks that rely on them."

Brexit Is A Shorter Term Stress On The System

We have a big event ahead of us. The most important players are working fast to avoid this risk. This Brexit vote is working ahead of the ARRC's timeframe. Hopefully it is not a risk, but it is front and center for this meeting.

They further said, "Because U.S. dollar (NYSEARCA:UUP) LIBOR is used in such a large volume and broad range of financial products and contracts, the risks surrounding it pose a potential threat to the safety and soundness of individual financial institutions, and to U.S. financial stability."

Fed Plans To Backstop A Shift From LIBOR Down The Road

As the Fed tries to shift away from LIBOR they realize they need large agreement and liquidity as soon as banks move their rate measures. The Fed is saying they will fund the liquidity in a transition period. They are saying that they will directly take part in the many transactions that fund using LIBOR including swaps and the vast array of derivatives.

Here's what they said, "given the potential for coordination failure and the large scale economies associated with reference rate choice, there is also a role for the official sector to influence the shift to a risk-free or near risk-free rate for the reference rates used in derivatives."

The Fed sees LIBOR as a risk and the transition from LIBOR as a risk. There will be a period of time that the Fed will be the principle provider for many complex transactions as a backstop.

The shift in transactions would take volume further away from the UK and Europe and place it in the US. A thin system may get thinner over time.

Other risks called out by governments

The Fed has said publicly that the UK decision is a risk event. The ECB said they are planning to be a backstop of safety liquidity. Many countries have pledged to support currencies if there are wild moves. This is a risk event, as we wrote on Sunday.

Exposure

The ARRC report cites that over 65% of all US derivative transactions trade based on the LIBOR. They reported that the total notional derivative market stands at about $200 Trillion. (See page 7)

The derivative market has the largest exposure out of any traded market. We know that the derivative market has a large reach of web transactions effecting most, if not, all market participants.

The lack of liquidity to determine the rates for these transactions is the reason the Fed wants to bring this part of the process home.

Conclusion, risk not overstated into Brexit

This gives us some idea of how multiple global players intimately care and are carefully following 1) what is the outcome, but more important, 2) what are the reactions, if any.

With such a huge amount of value tied up in UK decisions, you can be sure that the risk (whether markets ultimately react or not) is not overstated.

List of participants in ACCR to show importance of LIBOR, Brexit and a shift from LIBOR

Chair: Sandra O'Connor Chief Regulatory Affairs Officer & JP Morgan Chase & Co.

Voting Members: Bank of America, Barclays, BNP Paribas, Citigroup Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan Chase & Co., Morgan Stanley, Nomura, RBS, Société Générale, UBS, Wells Fargo

Non-voting Members: Bank of New York Mellon, CME, DTCC, ISDA, LCH.Clearnet

Ex Officio Members: Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York, U.S. Commodity Futures Trading Commission, U.S. Treasury Department, Office of Financial Research

Good luck and please be in touch. All of your comments teach US a ton.

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