The Federal Reserve Bank this week began publishing a new interest rate benchmark that underpins trillions of dollars in financial products, from mortgages to car loans. With the potential expiration in 2021 of LIBOR, the ubiquitous benchmark that has been a mainstay for nearly 50 years, focus is shifting to creating new—and hopefully better—benchmarks that will meet the needs of the financial community while reducing the opportunity for manipulation.
The University of Chicago Law School and the American Financial Exchange recently convened leading figures in law and economics and international finance to discuss how the new benchmark will affect rate-setting by banks, mortgage lenders, credit cards companies and other financial institutions—and the impact on hundreds of millions of consumers. The topic is of special importance to scholars of law and economics—a field born at the University of Chicago Law School that has transformed nearly every area of law.
“Our faculty is known for asking fundamental and important questions,” said Thomas J. Miles, dean of the Law School. “This conference is an example of that because it asks fundamental and important questions about our financial system: Namely, what is the true cost of money? Who should determine that cost? And how should they determine it?”
The Law School’s Coase-Sandor Institute of Law and Economics co-sponsored the April 3 symposium to begin a discussion on the transition to LIBOR alternatives being introduced. SOFR, the Secured Overnight Financial Rate designed by the Alternative Reference Rate Committee (ARRC), is an overnight secured lending rate based on the U.S. Treasury repurchase agreement market; it was published by the New York Fed for the first time on April 3. Ameribor, created by the American Financial Exchange, reflects the borrowing costs of US small-and mid-sized banks using a 30-day rolling average of the weighted average daily volume in the AFX overnight unsecured market. Two years ago when AFX started, it was trading $5 million and $10 million a day with six participating banks. Today, it has 83 member institutions and has traded as much as $780 million in a single day.
“With contracts tied to LIBOR that are valued at hundreds of trillions of dollars, practitioners need to prepare for this change in the reference rate to minimize its disruption to the financial markets and ensure an orderly transition," said Richard Sandor, CEO of AFX and the Aaron Director Lecturer in Law and Economics at the University of Chicago Law School. “We need to understand what the potential transition to SOFR and Ameribor means.”
While dissatisfaction with LIBOR has been linked to scandals of manipulation that surfaced during the financial crisis, the main impetus for change is LIBOR’s instability and lack of underlying transactions, according to David Bowman, special adviser to the Federal Reserve Board and the conference’s keynote speaker.
“LIBOR is based on markets that are not robust. That means you have to rely on the expert judgment of the panel banks, and most of them on most days don’t report a value of LIBOR that is based on any transactions from that day. Rather, they base their submissions on their expert judgement of what they could have borrowed at that day,” Bowman explained.
Recently two banks left the US dollar panel, and others are questioning their willingness to continue to participate, raising the specter that LIBOR may not exist past 2021.
The impact would be enormous. About $200 trillion worth of financial contracts are written on LIBOR, of which 95 percent are derivatives and about $10 trillion are cash products. None of these contracts include language to deal with the end of LIBOR.
“So if LIBOR stopped today, a bunch of really terrible things would happen based on existing contract language, seriously threatening U.S. and global financial stability,” Bowman said. “It’s not an allegiance to LIBOR itself, but rather how intertwined LIBOR is in a host of legacy trades; unwinding them will be difficult."
Yet, there is good news. About 92 percent of these legacy trades will roll off before 2021, and importantly—starting now—much of the risk related to LIBOR can be reduced immediately if better contract language is written into new trades, providing an economically sensible alternative if LIBOR stops functioning.
“If you write that into contracts now, you will take care of the bulk of your risk, and it would be fairly free,” Bowman said.
While ARRC has considered a number of reference rates as alternatives to LIBOR, it selected SOFR because it has become the most robust. Currently, the average notional daily volume of repo trades captured by SOFR is about $900 billion, compared with, $75 billion in the overnight Fed Funds market and $13 billion in US Treasury Bills.
“The Fed is not saying there can’t be a variety of reference rates, or that everyone has to trade SOFR, or that LIBOR can’t continue," Bowman continued. But if you want something to replace LIBOR potentially, it has to be the most robust rate you can find; it has to support $200 trillion: SOFR can do that.”
Randall Kroszner, the Norman R. Bobins Professor of Economics at the University of Chicago Booth School and a former governor of the Federal Reserve System, sees value in using different benchmarks for different situations.
“If you can use a benchmark based on transactions, you reduce the potential for bias. But if it is valuable to have a benchmark without many underlying transactions, you make the trade-off and see how the market develops. After all, LIBOR has stayed with us for a long time, despite its potential for bias,” Kroszner said. “As we think about the transition from LIBOR, we have to consider whether we want to mandate a move in a particular direction or let some spontaneous market forces develop such as the creation of the Ameribor reference rate, which was developed by Richard [Sandor] and his colleagues at AFX for small and medium-sized banks. It may not be the right benchmark for all contracts, but it could work for a certain set. ”
Kroszner suggested there could be a benchmark competition as institutions seek out different options for different circumstances: secured versus unsecured, robust versus limited. In the future, it could be very important to have multiple benchmarks so if something does change, it will make the transition easier and give regulators more flexibility to consider different alternatives.
The legal implications around the transition are large and uncertain, regardless of the benchmark that is chosen, according to Eric Posner, the Kirkland and Ellis Distinguished Service Professor of Law at the University of Chicago Law School. So a few scenarios can be considered.
“The first is, if everybody depends on LIBOR, is there any way to keep it going? Another possibility is to calculate LIBOR in a different way,” Posner said.
Most important, however, is the language in the contract.
“Dr. Bowman encouraged people—as they enter new contracts—to have a fallback with a different reference rate. If that’s the case, the courts will enforce the new term. However, it may be difficult to decide on the fallback rate. You want something that is an economic equivalent to LIBOR, but if you get it wrong, there will be a problem,” Posner explained.
Without a fallback term, it is likely the legacy contract would be upheld as frustrated and the contract would be terminated, with terms possibly being netted out. And there is always the potential, although unlikely, that the court could rewrite the contract.
“What to do about this? It’s important as people design benchmarks that they consider the long-term risks. And people who use them in contracts should think about including fallbacks and safeguards, despite the risks they create. In addition, people who establish benchmarks should be aware of the potential liability,” Posner added.
“We also have to think more about whether a regulatory agency should play a more active role in not only helping to establish benchmarks in the first place, but also in managing them as we go forward.“