A Federal Reserve-convened committee has narrowed its search fora replacement to Libor, the inter-bank interest rate underpinningtrillions of dollars of derivatives and other lending transactionsthroughout the financial system that has been rocked by fraudscandals in recent years.

A report released Friday by the Alternative Reference RatesCommittee, a group that includes representatives from the privatesector and regulators, proposed two possible replacements for theLondon Inter-Bank Offered Rate. The U.S. central bank's benchmarkfederal funds rate was considered, but ultimately discarded as anoption because choosing it “could be seen as a constraint onchanging the monetary policy framework” in the future, according tothe report.

Jump-starting either of the proposed alternatives would requiremoving derivatives contracts that currently reference the fed fundsrate to the new rate, which would further lessen the market'sreliance on the benchmark that serves as the target of U.S.monetary policy.

“The conception of this thing was clear, and is, I think, prettybroadly agreed, but execution is challenging,” Fed Governor JeromePowell said in an interview. The report “lays out a path goingforward. We can make this path work.”

Libor is used as a reference in the pricing of more than $160trillion of derivatives contracts and trillions of dollars more ofbusiness loans and mortgages, according to the ARRC report.Regulators realized the need to replace it after a series of fraudscandals revealed how easy the rate was for traders tomanipulate.

Two Options

A new metric the Federal Reserve Bank of New York beganpublishing in March, called the overnight bank funding rate, is thefirst option. That rate adds roughly $250 billion of dailyeurodollar transactions — which are largely banks borrowing fromnon-bank financial institutions, like money-market mutual funds —to the roughly $70 billion of daily fed funds transactions that gointo the calculation of the effective fed funds rate.

The second option under consideration is a rate based ontransactions in the market for repurchase agreements collateralizedby Treasury securities. The viability of this alternative is not asclear, as the Fed has not yet begun producing such a rate, althoughit's considering doing so, according to the minutes of the FederalOpen Market Committee's December meeting.

Getting market participants to transition trillions of dollarsworth of contracts to a new reference rate is no easy task. TheARRC report laid out a strategy, but cautioned that more needs tobe done in consulting with users of Libor and working throughoutstanding regulatory issues.

The report called for comments on the proposal to be submittedto the committee by July 15, and said the group will host aroundtable at the New York Fed on June 21 to further discussions ofthe process.

U.S. Treasury Acting Assistant Secretary for Financial MarketsDaleep Singh said in a statement that the “Treasury looks forwardto engaging with market participants to discuss the choice of analternative rate and an appropriate transition strategy.”

Bloomberg News

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