So much easier said than done, this saga has now extended to nearly mark an entire decade spent wasted on bureaucratic demands at the expense of common sense. Typical, I know. However, the stakes couldn’t be higher. This is the lynchpin which holds together vast expanses of global credit and money, trillions in loans and debt along with hundreds of trillions gross notional to derivatives contracts.
Yes, LIBOR.
Why are we still talking about it and the banking system’s forced-transition just about ten years after the scandal which saw this fundamental money rate tarred as the “crime of the century?”
It begins with what LIBOR had been – not the misconduct with which it was later labeled, rather a very obvious thorn in the side of especially American central bankers. When the outrage first appeared over banks supposedly cheating (for fractions of basis points) the interest rate’s various fixes, back in July 2012, officials made it a huge public case for other reasons.
Riding a wave of media-created public outrage, as if grandma’s nickels had been stolen by a rabid cabal of heartless, lustful Wall Street barons, emotion was poured onto the fire lit by resentment smoldering after the 2008 crisis. A clue here.
Yet, in private, LIBOR was rarely – if ever – discussed. There was only a single, one-off mention of the newspaper accounts reporting on Barclays (only implicating a few others) during the FOMC’s policy session held on July 31, 2012. From that gathering all the way until the June 2013 meeting, the word LIBOR (forget “eurodollar”) doesn’t appear once in any of the six and a half meetings in between.
An entire year, and the Federal Reserve’s official policy committee doesn’t want to talk about what its own people were insinuating had been the worst financial outrage ever?
Maybe that was because over the FOMC meetings held before July 2012, though LIBOR wasn’t brought up all that often, either, when it was the context, and LIBOR’s clear implication, was immensely unfavorable to the Federal Reserve. Comments such as the one below from the emergency conference call held on November 28, 2011, an unscheduled discussion made necessary by something big going wrong despite the genius that was Operation Twist instituted not long before:
“Moreover, the implied three-month dollar funding rate that could be obtained by borrowing at euro LIBOR and using FX swaps to convert to dollars has moved up sharply, reaching 200 basis points last week. Liquidity in the FX swaps market has worsened for horizons beyond one month.”
Or this policy dialogue from just a few months earlier, admitting to rapidly deteriorating conditions into what would lead the FOMC deciding upon Twist in the first place:
“We’re seeing it in markets more broadly in terms of widening in the FX dollar swap basis and a bit of upward pressure in dollar LIBOR rates. It’s hard to know if this is it or if we’re going to see a lot more of that, but it is certainly disturbing.”
Yes, it was disturbing, and the monetary system would, in fact, “see a lot more of that” not the least because it continued to get priced into, you guessed it, LIBOR. The Fed’s balance sheet throughout 2011 into 2012 had been ballooned already by two QE’s, the second which had ended mere weeks prior to the FOMC quote above, leaving the banking system with about $1.7 trillion in bank reserves.
Or about twenty-nine times more bank reserves than the Federal Reserve had ever produced in its one hundred years of sordid prior history.
In other words, LIBOR provided the whole world with a very public refutation of both bank reserves and the policies behind them. When put together with other prices/indications such as the swaps likewise being discussed in the same context, there was no mistaking what actually had happened before, or was going on again.
Despite this, the banking system initially went along with the official plan to scrap LIBOR anyway! This aging set of benchmark interest rates, which debuted all the way back in the 1969 London City offices of Manny Hanny, wasn’t perfect and even if there hadn’t been a scandal it could still use an update. No one really objected to finding a better way to price all of global finance regardless of the Federal Reserve’s true motives.
Time and again, however, it was those motives which interfered. While the FOMC was apparently loathe to discuss LIBOR throughout 2013 (only seven total references, most off-hand having nothing to do with the rate-switch) and the first half of 2014, a few relevant conversations began to appear in the deliberations around mid-2014 once the Alternative Reference Rates Committee (ARRC) officially took up the task.
As to their goal, Fed Vice Chairman Bill Dudley (Dudley, of all people!!) actually nailed it, for once:
“VICE CHAIRMAN DUDLEY. Everyone knows LIBOR is a troubled reference rate, yet people are still using LIBOR in all of their derivatives contracts. So I would prefer to avoid the problem of forcing the transition to the new reference rate by just actually giving people an improved reference rate, and then it happens simultaneously and we’re done with that problem.”
Right? How hard could this be? Give the system what it wants, what it absolutely needs, done deal. Easy peasy.
In its cowardice, our “central bank” wasn’t having it. At this same June 2014 FOMC policy setting, its future Chairman, the wrong-footed Jerome Powell couldn’t quite square these competing interests:
“Market participants did not prefer an option that kept the old LIBOR alive and created a new rate with these improved characteristics. Instead, they preferred a rate that is called LIBOR, but that is no longer limited to London or to interbank lending, and it’s not an offered rate either [laughter] but, rather, is anchored in real transactions.”
Banks, again, were more than willing to work with regulators, all of them including the ARRC, to replace LIBOR with a set of reference rates that would ultimately do the same thing as LIBOR has for decades. Powell joked it was about the name when in reality it has really been about its basic substance all along.
No laughing matter, that’s not what officials have pursued. On the contrary, they instead, years later, offered SOFR – the Secured Overnight Financing Rate. SOFR is not LIBOR; by that I mean it doesn’t do what LIBOR does and has.
The banking system has consistently complained about this fact; as Dudley had said way back in the middle of 2014, come up today with a reasonable and solid replacement for LIBOR and the banks willingly sign up for it tomorrow and start writing contracts on it the day after. Instead, for years, “yet people are still using LIBOR in all of their derivatives contracts.”
More than half a decade later, in October 2019, ten of America’s largest regional banks wrote to the triumvirate of US regulators (Fed, FDIC, and OCC) pushing back hard on SOFR. Several months before, June 2019, amidst massive financial upheaval, the Federal Reserve’s Vice Chairman for Bank Supervision Randall Quarles had unleashed a more-than-modest tempest when he opined on the subject of the LIBOR switch:
“Beginning that transition [to SOFR] now would be consistent with prudent risk management and the duty that you owe to your shareholders and clients…There is, however, also another and easier path, which is simply to stop using Libor.”
Those ten under Quarles’ supervision responded, with a palpably nonplussed tone, stating outright that SOFR “is not well suited to be a benchmark for lending products.” Putting it bluntly, they wanted, no laughter this time, an actual LIBOR alternative.
“During times of economic stress, SOFR (unlike LIBOR) will likely decrease disproportionately relative to other market rates as investors seek the safe haven of U.S. Treasury securities.”
There it is; SOFR, as its own name declares, is a secured overnight rate made up out of repo transactions. LIBOR, as an unsecured rate, must contain some sense of liquidity (and some credit) risks during those times of crisis, or even near-crisis. That it did so to the utter and repeated humiliation of the Federal Reserve while exposing the “central bank’s” deep flaws only further reinforced the real official disdain having nothing at all to do with criminal bankers.
The world needs to be informed of both sides here – a monetary breakdown as well as a clear picture of ineffective, even useless policy responses. LIBOR, for all its flaws, did this only too well and too often. Not LIBOR’s fault, policymakers just don’t know what they are doing.
That the banking system isn’t willing to let go of this demand is itself a profound indication of the same serious and ongoing mistrust. Though the level of bank reserves today is more than double what it had been during that 2011 stress point, the system still won’t take up SOFR willingly for need of a more accurate interbank stress indicator.
If the system was robust and dependably liquid with all those bank reserves, LIBOR’s replacement wouldn’t need to be so closely LIBOR-like.
There is a whole other issue with SOFR, too, including its lack of inherent term structure (as an overnight rate, even term SOFR derived from forward contracts isn’t at all the same thing as lending today at term). But just on the basis of its lacking risk component, adoption has continued to be uncertain, mixed, and leaves us all wondering over potentially a mess.
Last April, Zion’s Bancorp, one of those ten signatories from 2019, itself an institution with an $80 billion balance sheet, announced publicly it was going to use Ameribor rather than SOFR starting last summer. This other rate, like LIBOR, pertains to unsecured interbank lending though actually made up from real-market transactions unlike the “own” rate survey underpinning LIBOR.
Zion’s CEO simply said, “Ameribor … really comes closer to what the entire world has been using for the last 40 years.” Same information, an actual improvement.
SOFR, on the other hand, is nothing like it. And that, ladies and gentlemen, is and has been the official point all along.
Yet, on December 31, 2021, several LIBOR tenors were stopped entirely and US like UK banks were strongly cautioned (as in, threatened with scrutiny and penalties) against writing new loans and contracts based on those major LIBOR maturities which survive (until June 30, 2023, when each is currently scheduled to be phased out, too).
They’ve pushed a reluctant banking system globally into uncharted territory during a time when, to put it mildly, current global indications are flashing wildly uncertain. While the Fed and Bank of England are hiking their own rates over officially perceived inflation, inverted curves – including eurodollar futures, which still reference 3-month LIBOR right now – strongly suggest monetary and financial dangers which would look far more like 2011 than 1971.
Does this mean the whole world is about to come crashing down? No, but it sure doesn’t help at a time when anything less than full capacity is its own serious risk and downside case.
As a money dealer, let’s say you’ve written some new contracts based on SOFR because it was the path of least resistance rather than having made fundamental sense. Liquidity risks rise, but not for your pricing; you won’t be protected or even informed sufficiently by the key rate you let authorities choose for you over your legitimate protestations.
The most likely outcome from this is unnecessary complication, at best, and more than that heightened reluctance to go into the marketplace which might really need private monetary intervention given how, still to this day, bank reserves are irrelevant.
SOFR may actually prevent liquidity at the worst possible time; and if it does, those using SOFR wouldn't otherwise know it.
Dudley said it best (I can’t believe I just wrote that), just give the system what it requires, a true replacement for LIBOR. But because the banks are honestly attached to the information potential surrounding LIBOR, therefore any realistic equivalent, and all that comes with it, that itself is an outright contradiction to the Federal Reserve’s public position which is that there can no longer be any risks worth monitoring and measuring.
Like LIBOR’s ultimate outcome, this certainly remains to be seen.
