Finadium: repo indices could be best hope for replacing LIBOR
14 August 2012 Concord, Massachusetts
Image: Shutterstock
Repo indices could be a viable alternative to LIBOR as a global financial benchmark, according to a research report from securities and investment research firm Finadium.
The report comes in the aftermath of the LIBOR scandal, which rocked British banking.
Financial institutions contribute rates that are used in the calculation of LIBOR and EURIBOR. The contributed rates are supposed to reflect each bank’s assessment of the rates at which they can borrow unsecured interbank funds.
Futures, options, swaps, and other derivative financial instruments that are traded in OTC markets and on exchanges worldwide are settled based on LIBOR, and mortgages, credit cards, student loans and other consumer lending products often use LIBOR as a reference rate.
According to reports, certain Barclays traders requested that the Barclays LIBOR and EURIBOR submitters contribute rates that would benefit the financial positions that were held by those traders, and these requests were accommodated on numerous occasions when submitting the bank’s contributions.
Barclays paid the US Department of Justice a $160 million penalty to resolve violations. The US Commodity Futures Trading Commission ordered it to pay $200 million, and the UK Financial Services Authority fined Barclays £59.5 million for misconduct.
“The LIBOR scandal has been the tipping point for a change in short term interest rate benchmarks,” said Finadium in a statement. “But false submissions are just the start: the weaknesses in LIBOR go far beyond the current scandal and extend to its vulnerability as a carrier of counterparty credit risk. Mixing credit and interest rate risk in an unpredictable way is asking for trouble, but weaning the LIBOR benchmark of off $800 trillion in derivatives, loans, and mortgages is a daunting task.”
Finadium’s report looks at the options for new financial benchmarks, including Fed Funds, derivative Overnight Index Swaps (OIS) and repo indices. “Each have strengths and weaknesses, but ultimately the markets will turn to the products with the greatest liquidity backed by secured deposits and (hopefully) untainted by credit risk,” it said.
“Fed Funds and its derivative OIS are two options, but recent Federal Reserve and FDIC [Federal Deposit Insurance Corporation] changes have impacted Fed Funds liquidity.”
It said that the alternative “with promise” is repo, particularly repo on ‘safe assets’ such as US treasuries, agencies and mortgage-backed securities.
Finadium’s report examines the mechanics behind LIBOR and its alternatives to understand which existing benchmark “can be credible enough for the global marketplace”. It said: “While our best hopes lie with repo indices, these too are not perfect.”
“[T]he repo business has traditionally been opaque and not without its issues in the financial crisis. It is also part of the shadow banking investigations currently underway by the Financial Stability Board. New repo indices created by the DTCC go some way to address transparency issues, but indices alone will not create a new benchmark; a robust futures and derivatives market must also be part of the solution.”
The report comes in the aftermath of the LIBOR scandal, which rocked British banking.
Financial institutions contribute rates that are used in the calculation of LIBOR and EURIBOR. The contributed rates are supposed to reflect each bank’s assessment of the rates at which they can borrow unsecured interbank funds.
Futures, options, swaps, and other derivative financial instruments that are traded in OTC markets and on exchanges worldwide are settled based on LIBOR, and mortgages, credit cards, student loans and other consumer lending products often use LIBOR as a reference rate.
According to reports, certain Barclays traders requested that the Barclays LIBOR and EURIBOR submitters contribute rates that would benefit the financial positions that were held by those traders, and these requests were accommodated on numerous occasions when submitting the bank’s contributions.
Barclays paid the US Department of Justice a $160 million penalty to resolve violations. The US Commodity Futures Trading Commission ordered it to pay $200 million, and the UK Financial Services Authority fined Barclays £59.5 million for misconduct.
“The LIBOR scandal has been the tipping point for a change in short term interest rate benchmarks,” said Finadium in a statement. “But false submissions are just the start: the weaknesses in LIBOR go far beyond the current scandal and extend to its vulnerability as a carrier of counterparty credit risk. Mixing credit and interest rate risk in an unpredictable way is asking for trouble, but weaning the LIBOR benchmark of off $800 trillion in derivatives, loans, and mortgages is a daunting task.”
Finadium’s report looks at the options for new financial benchmarks, including Fed Funds, derivative Overnight Index Swaps (OIS) and repo indices. “Each have strengths and weaknesses, but ultimately the markets will turn to the products with the greatest liquidity backed by secured deposits and (hopefully) untainted by credit risk,” it said.
“Fed Funds and its derivative OIS are two options, but recent Federal Reserve and FDIC [Federal Deposit Insurance Corporation] changes have impacted Fed Funds liquidity.”
It said that the alternative “with promise” is repo, particularly repo on ‘safe assets’ such as US treasuries, agencies and mortgage-backed securities.
Finadium’s report examines the mechanics behind LIBOR and its alternatives to understand which existing benchmark “can be credible enough for the global marketplace”. It said: “While our best hopes lie with repo indices, these too are not perfect.”
“[T]he repo business has traditionally been opaque and not without its issues in the financial crisis. It is also part of the shadow banking investigations currently underway by the Financial Stability Board. New repo indices created by the DTCC go some way to address transparency issues, but indices alone will not create a new benchmark; a robust futures and derivatives market must also be part of the solution.”
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