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Frequently Asked Questions


Existential Questions

Paced Transition Strategy

Alternative Rates – EFFR/OBFR

Alternative Rates – Repo

Alternative Rates – Other forms of Benchmarks

 

Existential Questions

What is the ultimate purpose of this exercise – is it to find a better alternative to the effective fed funds rate (EFFR) or replace U.S. dollar (USD) LIBOR?

In line with the Financial Stability Board’s Reforming Major Interest Rate Benchmarks and the recommendations in the Financial Stability Oversight Council’s 2013-16 Annual Reports, the ARRC’s goal is to develop a strategy to move a significant portion of derivatives trading from instruments referencing USD LIBOR to a more robust alternative rate. The ARRC’s goal is not to eliminate USD LIBOR completely. While the ARRC’s paced transition strategy would move price alignment interest and eventually discounting from the effective fed funds rate (EFFR) to the new rate, this strategy has been developed in order to create an initial level of liquidity in swaps and futures referencing the new rate chosen by the ARRC, not to achieve any goal related to replacing or reducing use of the EFFR.

Is the new rate going to replace only overnight LIBOR, or all currently existing LIBOR fixings?

The ARRC’s goal is to encourage the development of sufficient liquidity in futures and swaps markets referencing the new rate so that trading in these markets can replace a significant portion of current trading in interest rate derivatives referencing all of the USD LIBOR fixings, not simply overnight USD LIBOR.

Why would market participants voluntarily trade this new benchmark? What is the incentive for market participants to consider a transition to trading futures and swaps in a new rate that may initially have lower liquidity than effective fed funds rate or LIBOR?

The ARRC believes that long term liquidity and confidence in the markets that currently reference USD LIBOR will be strengthened considerably to the benefit of all market participants if such markets are able to identify and actively trade a robust alternative. The ARRC believes that all market participants will come to share this view.

There are several reasons for this belief. As noted by the Financial Stability Board’s Market Participants Group, there are many current uses of LIBOR which would be better suited to a rate that is closer to risk-free. Indeed, given that banks’ borrowing in unsecured term money markets has declined noticeably, there is little need for a rate that reflects the cost of such funding. More importantly, the secular decline in short-term unsecured wholesale funding has made the market underlying LIBOR both less liquid and much less resilient. As a result, the majority of LIBOR submissions must still rely on expert judgment, and even those submissions that are transaction based may be based on relatively few actual trades. This calls into question LIBOR’s ability to ultimately satisfy IOSCO Principle 7 regarding data sufficiency, which requires a benchmark be based on an active market. While the IOSCO Principles do not preclude the use of expert judgment, it has been questioned whether a rate on which hundreds of trillions of dollars of contracts are based should rely on such judgment except in the most exigent circumstances. IOSCO has noted that the application and implementation of the Principles should be proportional to the size and risks posed by each benchmark, and given its scale of use, USD LIBOR should be held to a higher standard.

Despite the substantive reforms enacted by ICE Benchmarks Administration, the scarcity of underlying transactions poses a continuing risk of discontinuity or even cessation in the production of USD LIBOR. Ongoing regulatory reforms and changing market structures raise questions about whether unsecured short-term borrowing transactions may become even scarcer in the future, particularly in periods of stress, which exacerbates these concerns. Absent regulatory encouragement or mandate, banks may feel little incentive to contribute to USD LIBOR panels if transaction volumes erode further given the potential legal risks that have been associated with historical contributions and the lack of any direct benefits from panel participation.

The threat of a sudden cessation of such a heavily used reference rate poses particular risks. It would impair the normal functioning of a variety of markets, including business and consumer lending that reference USD LIBOR, and it could entail substantial losses and uncertainty for the market participants that have chosen to rely on USD LIBOR as a benchmark. It may create substantial legal challenges and could cause considerable disruptions to and uncertainties around the large gross flows of USD LIBOR–related payments and receipts between financial institutions. Importantly, these disruptions would be substantially greater if there were no viable alternative to USD LIBOR that market participants could quickly move to.
For all these reasons, the ARRC believes that identifying robust alternative rates and promoting their use is in the interest of all participants in the markets that currently use USD LIBOR as a reference rate.

Assuming the goal is to replace USD LIBOR, why is any new rate more likely to succeed than OIS given how small an impact OIS have had on the broader swaps market? Are we at risk of creating a third reference rate for swaps that will decrease liquidity in the other products without achieving widespread adoption? 

Successful implementation will obviously require support and participation from a broad set of market participants. This effort would certainly entail costs, but continued reliance on USD LIBOR on the current scale of use could entail much higher costs in the event that unsecured short-term borrowing declined further and submitting banks chose to leave the LIBOR panels, especially if there were no viable alternative to which trading could move. Therefore, the ARRC believes that a transition to alternative rates is in market participants’ own long term interest, despite the complications that it may pose in the short term. The ARRC’s Interim Report already reflects the willingness of a diverse set of banks and clearing houses to participate in and encourage movement to a new rate, and the plans they have outlined will have nontrivial costs to these institutions. If ARRC members, the official sector, and end users all continue to participate in and support finalizing these plans, then a transition can successfully be made with the least disruption to the market as a fairly smooth process, with minimal risk that the adoption of the new rate will fail while liquidity in current existing products is decreased.

Will the ARRC coordinate its decisions with the other currency groups?

The ARRC has kept in close contact with other currency groups, and will to the extent possible, seek to coordinate its efforts and proposals with them. However, institutional differences across markets may ultimately lead some currency groups to make different choices than others, and a higher level of bases across currencies could prove to be unavoidable.

 

Paced Transition Strategy

Is there a plan to run an industry netting of OIS risk as well as the new benchmark? While it makes sense to implement a “paced transition” as opposed to a “big bang,” it would be helpful to develop market venues particularly in the bilateral market that, on a periodic basis (i.e., quarterly,) undertake multilateral conversions of outstanding trades to trades governed by the new rate.

As discussed in the Interim Report, mechanisms for closing out legacy contracts will need to be devised in order to both meet likely market demand and ensure the safety and soundness of the CCPs in case of a member default involving a significant legacy book. Some ARRC members have also expressed interest in exploring mechanisms to accelerate the closing of legacy contracts, but no details have yet been discussed within the ARRC, and the feasibility of mechanisms of this nature would depend on individual capabilities and interests. Robust basis markets between the new rate and both LIBOR and the EFFR would also help to facilitate the voluntary closing of legacy contracts and will help to smooth the transition process. The ARRC will continue its planning for these types of mechanisms and for building basis markets.

How would a new benchmark work for legacy swaps trades referencing LIBOR? Would they still be quoted and would there be liquidity? Would they be able to be re-couponed based on new benchmark curve?

As discussed in the Interim Report, under the paced transition plan cleared legacy trades would continue to exist in the same pool under their current contractual terms until such time as they mature or are closed out. Robust basis markets between the new rate and both LIBOR and the EFFR would help to ensure some liquidity in legacy contracts. In addition, mechanisms for closing out legacy contracts will need to be devised in order to meet likely market demand and to ensure the safety and soundness of CCPs in case of a the default of a member with a significant legacy book, and methods for accelerating close out may also be considered by the ARRC.

Will CCPs be able to provide daily valuation for these new curves?

The steps in the ARRC’s paced transition plan envision building infrastructures to trade futures and swaps referencing the new rate. Implementation of this step and subsequent trading would then allow CCPs and other market participants to build daily valuations for these new curves.

Why is discounting using the new rate not being implemented contemporaneously with the trading of new-rate swaps? Is there any perceived benefit to having the first new-rate swap trade be discounted using OIS referencing the effective federal funds rate?

The timing of a move to discounting using the new rate will depend on several conditions. The ability to discount using a curve based on the new rate will depend on first establishing liquidity in swaps and futures markets referencing the rate, enabling CCPs and other market participants to model and establish daily valuations for these curves. The willingness of CCPs and other market participants to use the new rate as the discount rate to value swaps referencing the new rate or other rates will then depend further on the rules and procedures set out by each institution and will depend crucially on the perceived market demand for such a change and on the understanding that the new discount curve accurately reflects market pricing.

When discounting at CCPs finally moves to the new rate, what happens to the legacy trades that were previously discounted at OIS based on EFFR?

As discussed above, the willingness of CCPs and other market participants to use the new discount rate to value swaps referencing the new rate or other rates will then depend further on the rules and procedures set out by each CCP and will depend crucially on the perceived market demand for such a change and on the understanding that the new discount curve accurately reflects market pricing. At such time that a CCP decides to move discounting to the new rate exclusively, then all swap products would be valued at the new discount curve, including legacy trades.

If swaps referencing the new rate are not clearable on day one of trading, is it possible to obtain regulatory exemption from bilateral margining rules?

The U.S. official sector has convened the ARRC and is supportive of its goals, but issues such as regulatory exemption would need to be considered by the relevant public authorities according to their procedures, and the ARRC cannot comment on what those authorities might choose to do.

How would you trade products that have been historically quoted off of USD LIBOR if there was a switch? What does the ARRC suggest we do with loans and other derivative instruments tied to USD LIBOR? Would you encourage banks and other lending institutions to move to new rates for consumer products? Would MBS or MBS floaters have to be repriced?

The ARRC’s mandate is to formulate a plan to move a significant portion of new derivatives trades that currently references LIBOR to a more robust alternative rate. The ARRC has not been asked to move all trading or all products to a new rate; however, the structural integrity of USD LIBOR has been challenged as the scarcity of underlying transactions poses a continuing risk of discontinuity or even cessation in the production of USD LIBOR, so institutions should consider moving away from LIBOR. Although the decision to adopt a new rate needs to be made by each institution, as the alternative rate gains in liquidity and market share, it is likely that some products will move to reference the new rate or quote pricing off of it. Under the ARRC’s paced transition plan, legacy contracts referencing USD LIBOR would continue to do so, unless the counterparties involved collectively wanted to renegotiate the terms of their agreements or if LIBOR ceased to be published.

How long do you expect the transition to the new rate to take?

The ARRC recognizes that its proposed recommendations could take several years to accomplish, but the committee does not yet have an exact time line and, due to the voluntary nature of the transition, continuing consultation with end users will be crucial in developing the ARRC’s final planning. The ARRC has considered and rejected plans that call for a quicker and potentially more disruptive transition. Although developing a threshold level of liquidity as laid out in the ARRC’s paced transition plan will happen over several years and may at the outset appear to be fracturing liquidity, it will allow for netting and approximate position compression that will ultimately make transition to the new benchmark much easier in the future.

 

Alternative Rates - Effective fed funds rate (EFFR)/overnight bank funding rate (OBFR)

Are there any plans to stop publishing the effective federal funds rate (EFFR)?

The Federal Reserve has not stated any plan to stop publishing the effective federal funds rate, and therefore the ARRC knows of no reason for market participants to anticipate that it will stop being published.

Couldn’t the Federal Reserve just change the definition of the EFFR to include the Eurodollar transactions included in the OBFR rather than going through a lengthy and uncertain migration process?

The Federal Reserve has not stated any plans to change the definition of the EFFR, and therefore the ARRC know of no reason to anticipate that the definition of the EFFR will change.

Why hasn’t the ARRC chosen the EFFR as a candidate rate? Given trading in EFFR-based OIS and the fact that price alignment interest and discounting are already based on EFFR, wouldn’t choosing this rate avoid significant disruption?

The ARRC’s Interim Report lays out several reasons for preferring the OBFR to the EFFR. The OBFR reflects roughly $300 billion in both daily overnight federal funds and Eurodollar transactions, while the EFFR reflects roughly $70 billion in daily overnight federal funds transactions only. Although the number of transactions underlying the EFFR is substantial, the number of counterparties currently lending in this market is fairly limited. Over 90 percent of overnight federal funds transactions are arbitrage trades lent by one of the government sponsored entities to banks that deposit the funds to earn the Federal Reserve’s IOER rate. There are a number of risks that could cause many of these arbitrage trades to quickly cease, and hence the ARRC believes that the OBFR would be a more robust choice than the EFFR. Finally, the ARRC also believed that promoting the use of a current policy target rate such as EFFR as an alternative to LIBOR could instill expectations that the FOMC would maintain the current policy framework. Because the OBFR is not the current the target rate of the FOMC, these considerations do not affect it.

Have you considered that the low level of volume in the Fed Funds market is only due to the current low rate environment?

The ARRC would like to focus on where they believe the market will be in the future, and they are operating under the assumption that the interbank market will not return to prior levels. In the ARRC’s opinion, the level of rates and the current monetary policy regime aren’t primary drivers to the secular decline in wholesale funding. Instead, they believe it is driven more by the changing regulatory environment and evolving models of bank funding.

Despite enhanced liquidity, is a rate such as the Overnight Bank Funding Rate (OBFR) that is based on a more complicated definition – and, notably, a less-than-transparent Eurodollar market – really preferable to LIBOR or the EFFR?

The OBFR is a fully transaction based, and therefore transparent, rate based upon a large and robust market and collected under formal rule-making from over 160 banks by the Federal Reserve. As such, it is far more resilient than USD LIBOR, where most submissions must rely on the expert judgment of a small number of banks that, absent regulatory encouragement or mandate, may feel little incentive to contribute to USD LIBOR panels if bank borrowing in term unsecured money markets erode further given that they incur potential legal risks in doing so and receive no direct benefits.

As noted in its Interim Report, the ARRC believes that the OBFR would be a more appropriate choice than the EFFR for several reasons. By incorporating Eurodollar transactions, the OBFR captures a much larger market. The OBFR has roughly $300 billion in underlying transactions while the EFFR has roughly $70 billion. Eurodollar transactions are conducted offshore, but are captured by the same FR2420 data collection as the federal funds transactions incorporated into the EFFR and in that sense are as transparent. The institutions transacting in the Eurodollar market and their reasons for doing so are also more diverse. Finally, the ARRC also believed that promoting the use of a current policy target rate such as EFFR as an alternative to LIBOR could instill expectations that the FOMC would maintain the current policy framework. Because the OBFR is not the current the target rate of the FOMC, these considerations do not affect it.

Modeling a new rate such as the OBFR will require a sufficient period of historical data. Meeting the requirements under the BIS Fundamental Review of the Trading Book (“FRTB”) proposal will also require historical data. Given that the OBFR may be quite different to the EFFR in terms of who the borrowers and lenders are and that it is difficult to envisage how volatile OBFR could be relative to the EFFR in times of stress, isn’t this a significant issue that might delay adoption?

The OBFR and EFFR have been published in the current forms since March 2016 and have been quite close to each other during that period. While the OBFR did not exist prior to this time, the Federal Reserve Bank of New York has published historical data on a “brokered” OBFR based on broker submissions, similar to the type of broker submissions previously used to produce the fed funds effective rate.¹ These data can serve as a potential proxy for the OBFR and go back before the crisis, allowing market participants to model to the potential properties of this rate. As can be seen in the accompanying figure, these data indicate that the OBFR would have moved very closely with the EFFR, although there were periods of time during the financial crisis when the OBFR traded higher than the EFFR.²

chart

¹ The “brokered OBFR” and other data were provided in accompaniment to “Money Markets after Liftoff: Assessment to Date and the Road Ahead,” Simon Potter (Feb 22, 2016).
² Eurodollar and federal funds rates diverged during the crisis as the two markets became segmented. Lenders in the federal funds market, mainly GSEs and banks, lent to relatively less risky borrowers, which helped maintain low average rates. Banks perceived to be more risky remained able to borrow in the Eurodollar market at higher rates, generally from money market funds and corporations. In other words, the federal funds market was likely serving borrowers with less credit risk, whereas the Eurodollar market was also catering to borrowers whose credit risk was perceived to be higher. Once liquidity strains subsided, borrowers were able to secure funding at more similar rates and the spread between rates in the two markets markedly declined.

How is the OBFR calculated? What are the mechanics for Eurodollar transactions included in it?

Information on both the calculation of both the OBFR and the EFFR rates can be found on the Federal Reserve Bank of New York’s public website.

Would OBFR be quoted on a term basis like LIBOR is today (i.e., 3-month, 6-month)?  Market participants, including consumers in the credit markets, are used to thinking about interest rate resets on a periodic basis and so this may be worth considering.

Both of the rates preliminarily identified by the ARRC are overnight rates. In both unsecured and secured money markets, overnight transactions are far more numerous and robust than term transactions. However, rate resets need not be overnight even if the underlying reference rate is an overnight rate. As described in the Final Report of the FSB’s Market Participants Group, loans could be based on a compounded average of the overnight rate chosen by the ARRC. This compounded average could be hedged fully by an OIS contract and its reset would occur monthly or quarterly, just as in current loan products. In addition, as the transition to the new rate progresses and OIS and futures markets referencing this rate develop sufficient liquidity, it may be possible to build other forward-looking term benchmarks from these markets if there is market demand. These benchmarks would themselves need to be highly robust and satisfy the IOSCO Principles.

If OBFR is selected for the paced transition, then shouldn’t a secured GC repo rate still be developed as the alternative to OBFR, particularly since it may perform better in times of stress?

The ARRC intends ultimately to recommend one rate to actively promote as an alternative, in order to concentrate liquidity. However, one or more new GC repo reference rates may ultimately be developed independent of whether the ARRC recommends such a rate. Regardless of which rate the ARRC recommends, market participants would be free to trade, develop, and market other rates, although those rates may not have as much liquidity over time than an alternative reference rate proposed by the ARRC and supported by a transition plan for implementation.

 

Alternative Rates - Repo

Might the multiple segments of the overnight repo market create additional complexities or nuances around any secured overnight rate that discourage adoption?

It is the case that there are several different segments within the overnight Treasury GC repo market, including uncleared triparty repo, cleared (GCF) triparty repo, and bilateral cleared and uncleared repo markets. The ARRC itself has expressed a preference for a more widely inclusive repo rate, if a repo rate is in fact ultimately chosen, but will need to consult with market participants to see if this view is shared. It is possible that including data from several different segments would create a more complicated rate. However, some participants appear to fund across several segments interchangeably, suggesting that there are some elements of commonality across them, and it may be the case that including more segments would allow a reference rate to more flexibly adjust to changing market conditions if market structures change over time. For example, if the market moves to greater use of clearing.

Are there concerns that ongoing balance sheet capacity issues and market structure changes could render a repo rate less predictable and representative than it has historically been?

Both unsecured and secured funding markets have undergone changes, due both to the financial crisis and more recently to regulatory and other structural changes. To the extent possible, the ARRC has taken this into account in selecting both the OBFR and an overnight Treasury GC repo rate as its preliminary leading candidates. In the ARRC’s consideration, both rates have remained resilient through the many recent changes and are the best potential candidates for selection. But the ARRC will also consult closely with other market participants, and their views of these issues will be an important driver in the ARRC’s ultimate choice of a rate.

Since the OBFR is ready, but having a GC repo rate could be very helpful, is the ARRC willing to be patient and wait for a repo reference rate? How important a factor is it for the ARRC re: the length of time before a transition to the new rate can occur?

The ARRC believes that it is important to pick the right rate for the long-run, and therefore is willing to wait if appropriate. As of now, the committee has no bias toward either of the two rates, but instead wants to have all the information on the potential options first, including additional feedback from end users on the rates under consideration.

 

Alternative Rates - Other forms of Benchmarks

Why can’t the new rate chosen by the ARRC be a hybrid between OBFR and overnight repo rates?

The ARRC hasn’t considered this, but it could. If there is market demand for this type of hybrid rate, then the ARRC would certainly take such views into consideration.

What if end users have a preference for another rate outside the two options highlighted by the ARRC?

The ARRC’s mandate is to identify a set of alternative reference interest rates that are more firmly based on transactions from a robust underlying market and that comply with emerging standards such as the IOSCO Principles for Financial Benchmarks, consulting with other interested market participants in order to achieve a broad-based perspective. The committee remains receptive to considering other potential alternatives as may be proposed by market participants that meet the criterion set out in the ARRC’s Interim Report.

About Us

Major reference rates are widely used in the global financial system as benchmarks for a large volume and broad range of financial products and contracts. In response to concerns regarding the reliability and robustness of these reference rates, The Financial Stability Oversight Council and Financial Stability Board called for the development of alternative interest rate benchmarks. In 2014, the Board of Governors of the Federal Reserve System and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee in order to identify best practices for alternative reference rates, identify best practices for contract robustness, develop an adoption plan, and create an implementation plan with metrics of success and a timeline.

The ARRC accomplished its first set of objectives and has identified the Secured Overnight Financing Rate (SOFR) as the rate that represents best practice for use in certain new U.S. dollar derivatives and other financial contracts. It also published its Paced Transition Plan, with specific steps and timelines designed to encourage adoption of the SOFR. The ARRC was reconstituted in 2018 to help to ensure the successful implementation of the Paced Transition Plan and serve as a forum to coordinate and track planning across cash and derivatives products and market participants currently using U.S. dollar LIBOR. To that end, the ARRC will endeavor to deliver recommendations for addressing risks in contract language, orderly transitions on a voluntary basis, and actions that would facilitate such transitions as it deems appropriate in order to meet these objectives.

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Contact for General ARRC Inquiries
ARRC@ny.frb.org

Contact for Chair Sandra O’Connor
Andrew S. Gray
JP Morgan Chase & Co
(212) 270-5651
andrew.s.gray@jpmchase.com