Reference Rates Upgraded to all new Avatars | (Part I of 3)

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This article is Part 1 of my explanation on recent recommendations suggested by the Financial Stability Board (FSB) on existing reference benchmark rates. Major reference interest rates (IBORs) are widely linked to many financial instruments and there is an exposure of trillions of dollars to these reference rates. Recent manipulation of these rates by certain financial firms has reduced the integrity and transparency of the existing reference rates. Hence, there has been a need to revamp these reference rates in order to make the market more robust and transparent and also eliminate the possibility of manipulating the reference rates. The article (combined in all three parts) gives an insight on key recommendations laid by FSB to revamp the reference rates, advantages and disadvantages of these proposed changes and also gives an indication upon what do market participants think about these recommendations.

What are Reference Interest Rates?

A reference rate is a rate that determines pay-offs in a financial contract and that is outside the control of the parties to the contract. Major reference rates are LIBOR, EURIBOR, and TIBOR etc. (collectively termed in this article as IBORs).

Inter Bank Offered Rate (IBOR) is the average interest rate estimated by leading banks in a particular jurisdiction that would be charged to the leading bank if it borrows from other banks. For London it is termed as "London Inter-Bank Offered Rate" (LIBOR), for Europe it is termed as "European Inter-bank Offered Rate" (EURIBOR) and for Japan it is termed as "Tokyo Inter-Bank Offered Rate" (TIBOR). The borrowing periods range from overnight to one year for which these interest rates apply. These interest rates are currently published based on the rates submitted by the panel banks to their corresponding authorities.

These reference rates are widely used in the global financial system as benchmarks for a large volume and broad range of financial products and contracts. Example, a Fixed-Float Interest Rate swap can have one payer with predefined fixed interest rate and other payer with floating interest rate which is linked to any one of the reference benchmark rates like LIBORs, EURIBORs etc. The payments of floating rate parties in the contract changes based on the movements in these benchmark rates.

The use of reference rates to price financial contracts reduces the complexity and facilitates standardization. This lowers transaction costs and enhances liquidity, especially if particular reference rates are widely used. As a result, certain reference rates are now deeply embedded in financial systems. Reference interest rates based on unsecured interbank term lending and borrowing have become dominant, partly because they facilitate the management of bank funding risk, but primarily because they were the first types of rates to be introduced, when bank credit spreads were low, and over time have emerged as the market standard facilitating the development of some of the most liquid financial instruments.

As a result, LIBOR, EURIBOR and TIBOR (the "IBORs") are now used in a wide array of instruments, including credit products and derivatives, as well as a number of corporate contracts, accounting, tax, capital and risk valuation methods.


Figure 1

This graph shows the total notional outstanding exposure against various reference rates. It has been observed that most reference rate activity is concentrated at the shorter tenors, with the 3 month tenor being the most active across currencies. The IBOR reference rates are used in a variety of derivative products and credit products as shown below.


Figure 2 - Credit Products


Figure 3 - Derivatives Products

How were IBORs insulted?


Figure 4 - Pinnochio

There have been cases of attempted market manipulation and false reporting of global reference rates to their corresponding administrators by a few market participants. The scandal arose when it was discovered that banks were falsely deflating their rates so as to profit from trades, or to give an impression that they were more creditworthy than they actually were.

As Libor is used in US derivatives markets, an attempt to manipulate Libor is an attempt to manipulate US derivatives markets, and thus a violation of American law. Since mortgages, student loans, financial derivatives, and other financial products often rely on Libor as a reference rate, the manipulation of submissions used to calculate these rates can have significant negative effects on consumers and financial markets worldwide.

These cases of attempted market manipulation and false reporting of global reference rates, coupled with the post-crisis decline in liquidity in interbank unsecured funding markets, have undermined confidence in the reliability and robustness of existing interbank benchmark interest rates. Uncertainty surrounding the integrity of these reference rates represents a potentially serious source of vulnerability and systemic risk to the entire financial system.

The price discovery process will remain vulnerable to manipulation without sustainable liquidity in unsecured interbank markets and strong governance frameworks, thereby affecting the credibility and reliability of benchmarks derived from these rates.

Loopholes in existing IBORs


Figure 5 - Loopholes

Unsecured interbank market activity in many jurisdictions has declined noticeably as banks have increased their reliance on broader wholesale unsecured and secured financing. While bank funding models have been evolving radically over the past decade, reference rate designs have not kept up with the developments in the wholesale funding market. A result of this, together with the growth in derivatives volumes, is a significant divergence between the use of IBORs and the degree of activity in their underlying markets. There is a need for an increased level of expert judgment and governance to fill this gap. This may increase the costs and the risks of using the IBORs not only to submitting banks but also to the broader market. A high concentration of contracts linked to the same reference rate may have important benefits particularly in terms of liquidity and ease of hedging, but may pose high risks to the overall system.


Figure 6 - Risks

In Part II, I shall introduce the crux of this article, that is the recommendations suggested by the FSB on upgrading existing benchmark rates to make them more transparent and reduce the incentive for market participants to manipulate these rates. I shall explain the evolution of IBOR+ and (Near) Risk Free Rates, which are the pillars of these recommendations set by the FSB, in the coming post.

Till then stay tuned!!!

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