LIBOR is an interest rate benchmark used as a reference rate. This reference rate reflects the general cost of large banks’ borrowing that is not backed by collateral. U.S. dollar LIBOR plays a central role in the U.S. financial markets and economy. It is used to set interest rates on financial products such as mortgages and private student loans.
The difference between LIBOR, formerly known as the London Interbank Offered Rate and now ICE LIBOR (Intercontinental Exchange LIBOR), and benchmark rates that reflect minimal credit risk is used as a measure of risk in banks and stress in financial markets.
Some banks attempted to manipulate LIBOR to increase returns on their derivatives positions and hide their risks during the financial crisis. Also, transaction volumes in LIBOR dwindled after the crisis. As a result, confidence in this reference rate dropped. The thin and declining base of transactions underpinning LIBOR led to calls for reform in the United States and abroad.
The Federal Reserve Board and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC) to identify an alternative to LIBOR. The OFR is a member of ARRC and has collaborated with the Federal Reserve and the Federal Reserve Bank of New York to develop three new rates. In June 2017, the ARRC selected one of these rates, the Secured Overnight Financing Rate (SOFR), as its recommended alternative to U.S. dollar LIBOR.
The SOFR is based on repo interest rates. A repo, or repurchase agreement, is a secured loan; one party sells a security to another party and agrees to repurchase it later at a set date and price. Because repos are a key source of short-term funding in the financial system, a rate based on these transactions is a good candidate for an alternative reference rate.
The SOFR will include overnight, Treasury-backed repo transactions that take place in the Bank of New York Mellon’s triparty repo system or are cleared through one of two Fixed Income Clearing Corporation platforms: (1) the Delivery-Versus-Payment Repo Service and (2) the General Collateral Finance (GCF) Repo Service.
The OFR plans to engage in rulemakings to establish permanent data collections covering some repo and securities lending transactions. Certain aspects of these data might be useful in the calculation of SOFR as a LIBOR alternative.
Prior to the ARRC’s work, the OFR collaborated with the Federal Reserve and the Securities and Exchange Commission to conduct two voluntary pilot projects to explore how to collect data about bilateral repo agreements and securities lending transactions.
The transition to a new reference rate will require broad acceptance by the financial markets. Collaboration between industry and government will be key to a smooth and fast transition. The OFR is involved in the planning for the alternative reference rate and is playing a role in its implementation.
In a related development, the Federal Reserve requested public comment in August 2017 on a proposal to compute SOFR and two other overnight, Treasury-backed repo reference rates in cooperation with the OFR. The other two are not intended to be LIBOR alternatives, but they may be useful indicators of funding costs in specific market segments. The Tri-party General Collateral Rate will be based solely on triparty repo transactions. The Broad General Collateral Rate will be based on triparty repo transactions and transactions cleared by the GCF Repo Service.
Director’s related blog: Time is Right for LIBOR Alternative (12/08/2016)
FEDS Notes article: The Cleared Bilateral Repo Market and Proposed Repo Benchmark Rates (2/27/2017)
ARRC press release: https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2017/ARRC-press-release-Jun-22-2017.pdf (6/22/2017)
Federal Reserve Notice and Request for Comment: https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20170824a1.pdf (8/24/2017)