How do you start it over?
You don't know if you can
And I know what's been on your mind
You're afraid it's all been wasted time
The LIBOR replacement proposed by the Alternative Reference Rates Committee (ARCC) appointed by the federal government, discussed here, is already threatened. UK Financial Conduct Authority head, Andrew Bailey, earlier put his considerable weight behind the ARRC proposal, in his July 27, 2017, speech, “The future of LIBOR.” Most recently (March 2, 2018), Bailey backtracked from his earlier support for an overnight rate, saying:
Now, I would not rule out that it might be possible to produce a form of LIBOR proxy which could satisfy the legal definition of what LIBOR is taken to be and serve as a legacy benchmark.
As Bailey indicated, there are two reasons the ARCC-proposed rate is a poor alternative. First, the ARRC rate tracks Treasury yields and thus will fall relative to banks’ cost of money during flights to quality – when the banks are most vulnerable to loss. Second, it cannot be used directly to form a forward-looking term rate. Averages of overnight rates look backward. Short of resetting loan and other securities rates tied to the index daily, the rate will provide a backward-looking index, not the forward-looking index provided by LIBOR.
Bailey suggests a cobbled-together version of LIBOR that includes a risk-free rate plus a “credit add-on.” The suggestion is a step in the right direction, theoretically speaking, but it would lose the primary advantage provided by the overnight rates. It would not be transaction-based.
The pressure to get the LIBOR replacement right is building. But London still has an opportunity to keep this market, as the US regulatory establishment always seems to show less imagination. But to hold on to its financial franchise, London must show some creativity.
Failure to identify a viable LIBOR replacement is a life-threatening issue for CME Group (CME) whose largest-volume contract is LIBOR-based Eurodollar futures. Equally threatened is LCH: Clearnet, the largest clearer of dollar-based interest rate swaps. A substantial revenue hole would also be created for the four US megabanks — Bank of America (BAC), Citigroup (C), Goldman Sachs (GS), and JPMorgan Chase (JPM) — which together clear 90% of the total cleared by US banks.
“The London bait-and-switch.”
What is so significant about this most recent Bailey speech is that it opens the door for an instant replay of the London bait-and-switch. What is the London bait-and-switch? It was the move that made London financial markets competitive those of New York during the 1970’s and 1980’s.
London emerged during the post-1970 chaos that bared the failure of the United States regulatory community to dismantle the antiquated financial system established following World War II. The post-WWII Bretton Woods Agreement nominally tied the dollar to gold but more importantly tied the value of other major currencies to the dollar – a fixed exchange rate regime. The resulting quiescent financial markets permitted the US government to establish a government-protected system that featured ceilings on interest rates the banks were permitted to pay on deposits, restrictions on branching, and a heavily subsidized system by which mortgage rates were funded through consumer savings accounts.
The post-1970 upward explosion of interest rates blew this antiquated system to bits. Most significantly, wholesale US deposit rates were up to 10% less than market interest rates on comparable risks.
London’s light-touch, entrepreneurial, regulatory system presents an attractive alternative to Washington’s slow-moving, economic-crisis-oriented system at moments like this, when the financial system’s profitability is threatened. The London banks, with the cooperation of the Bank of England, leaped into the void, offering dollar deposits at market rates. The result was a flood of wholesale dollar deposits into the London market.
Long story short, after 40 years of success, the edifice built upon London dollar deposits has come crashing down. A system born to replace a regulated system is doomed to be temporary. Either the new system adopts its own regulations, eliminating its old advantage; or the new system remains unregulated, ultimately leading to an unacceptable level of corruption. By all accounts, LIBOR is guilty of both.
The fall of LIBOR
Volume in the LIBOR-based market exploded, giving birth to more abusive instruments based on LIBOR, notably interest rate swaps and credit default swaps, financial derivatives that revealed their vulnerability at the beginning of the Financial Crisis when LIBOR markets froze. The large banks no longer were willing to spend their credit limits on interest rate risk management that could be otherwise managed in less credit-risky ways – for example, with Eurodollar futures.
The result was a sort of paradox of liquidity. The relatively safe Eurodollar futures markets sucked liquidity out of the LIBOR deposit market. But unfortunately, Eurodollar futures depend on the liquid deposit market they destroyed to determine the futures price. By robbing its namesake of liquidity, Eurodollar futures may be self-destructing.
How will a LIBOR replacement be found?
The existing proposals are non-starters. Bailey explains clearly the shortcomings of the ARRC proposals. Yet, the ARRC proposals, as well as Bailey’s earlier speech, argue against ad hoc methods, like a credit spread taken from thin air, then added to a Treasury rate, as Bailey suggests in his latest speech.
A recent Financial Times article highlights non-financial issues that make replacing LIBOR problematic, such as:
…switching to alternative benchmark reference rates would require the consent of all noteholders before the contracts can be altered. Market experts and lawyers say [this goal] is impossible to achieve.
The current approach to finding a LIBOR replacement is through the efforts of committees convened by regulators and trade organizations, such as the International Swap Dealers Association (ISDA), are doomed to fail. Committees do not innovate.
Consideration of an overnight rate as a LIBOR substitute has not been wasted time.
Nonetheless, there is a benefit in reading the tea leaves used by these committees to brew their concoctions. It is plain, for example, that the only source of market prices remaining in the short-term dollar interest rate market are overnight rates – various versions of Treasury-collateralized repurchase agreements, and uncollateralized commercial paper – or short-term Treasuries themselves.
I am puzzled that Treasury bills themselves have not received greater consideration. Treasury bills were once the basis for the Chicago Mercantile Exchange’s most successful short-term interest rate contract before it was muscled out by LIBOR futures.
The real LIBOR question
The Intercontinental Exchange (NYSE:ICE) LIBOR question that created the LIBOR scandal will soon enter the pages of history:
At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 am London time?
A better LIBOR question: How could a one-, three-, or six-month instrument be synthesized from an overnight rate that could realistically be named the London Interbank Offered Rate? This new synthetic LIBOR must be market priced.
One thing is certain: Synthetic LIBOR cannot itself be a deposit rate. That market has died.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.