2017-06-25

Further news regarding Alternative Reference Rates

A couple of days ago, the US Alternative Reference Rates Committee has published an announcement regarding its "preferred alternative reference rate". The announcement can be found on the New York fed web site at https://www.newyorkfed.org/arrc/announcements.html.

The proposed rate is based on repo transactions. It is certainly a useful new benchmark and a useful reference for "new USD derivatives". A discussed previously in this blog in post on similar subjects, and as implied by the name of the committee, this is an alternative reference rate, not a replacement of the LIBOR rate. The repo rates have a different credit implication than the inter-bank transactions underlying LIBOR. The risk management and valuation features of the two benchmarks will be different. The new benchmark will lead to "certain new U.S. dollar derivatives". Implicitly, this means also new markets, new clearing infrastructure, and new master agreements and CSAs.

The alternative benchmark is only proposed at this stage; it is not yet finalized and not yet published. Consequently there is no historical data available for analysis and no scrutiny on how it behaves on a daily basis. The author of the announcement acknowledge that its robustness is only a "likely robustness" and not a proven one.

The committee will propose "transition plans"; this is an important part of creating an alternative benchmark. Some LIBOR rate derivatives have maturity of 30Y or longer. The transition should be over that period. Any attempt to shorten that period will create risk management and valuation challenges for existing users. Solving them will require bilateral agreement specific to each existing contract; a committee imposed approach would certainly meet legal challenges.

The description of the new indices to be created can be found on the NY fed page
https://www.newyorkfed.org/markets/opolicy/operating_policy_170524a.

The exact definition of the benchmarks has not been finalized yet and the indices themselves have never been published. The proposed benchmarks are only Overnight rate; as such they are not a replacement for term LIBOR. Would the derivative market move to an overnight reference rate only market? Somehow I doubt this would be very practical for end users. Would corporate want to have daily fixing for their loans? What about floating rate mortgages?

The committee plan to publish its final report later this year. To my opinion, it will certainly take a fair amount of time, to be measured in years, before this alternative market is stabilized. If I take as reference the posts on this blog, the first one on the change of benchmark was published in 2014: Change of benchmark overnight index is a difficult task.  Almost three years later, the discussion has progress but very little has been happening in the actual derivative market regarding the benchmark.

TO BE CONTINUED