In November 2014 the Federal Reserve convened the Alternative Reference Rates Committee (ARRC). ARRC has two goals: first, to identify alternative reference interest rates that are more firmly based on market transactions; and second, to identify an adoption plan to facilitate the transition from LIBOR. This effort was largely spurred by the lack of actual observed data for certain LIBOR markets (certain currencies and maturities). How will ARRC affect community banks?
Dating back to 1984, the British Banker’s Association produced the Libor rate comprised of quotes from 18 banks covering 60 nations and 223 members. In June of 2012, as a result of the Libor scandal where it was found that banks colluded to manipulate rates, administration of the index was transferred to the Intercontinental Exchange (ICE) which is a U.S.-based (Atlanta) exchange. ICE instituted a more market-based methodology and incorporated greater checks and balances in reporting.
Despite the substantive reforms enacted by ICE Benchmarks Administration over LIBOR, the scarcity of underlying LIBOR borrowings in certain markets, in ARRC’s view, created a continuing risk of discontinuity or even cessation in the production of USD LIBOR in the future. ARRC set out to identify an alternative reference rate and promote that rate’s use by market participants in substitution to the currently use USD LIBOR.
On June 22, 2017, ARRC selected a preferred reference rate for U.S. dollar contracts. That rate is a Treasuries repo financing rate to be published by Federal Reserve Bank of New York (Overnight Bank Funding Rate or OBFR). The historical relationship between OBRF and effective fed funds rate (EFFR) is shown below from ARRC’s Interim Report.
ARRC chose the OBFR because it is fully transaction based, and therefore transparent. The rate is based on a large number of market participants and collected under formal rule-making from over 160 banks with over $600Bn in daily traded contracts. Multiple tenors are unlikely to be referenced (unlike LIBOR, which is quoted for many tenors).
Because of the dominance of LIBOR in U.S. dollar contracts, planning for the transition to the OBFR poses a host of challenges. ARRC plans to publish its final report later this year to outline the steps and timeline for the transition. However, on ARRC’s website the published announcements and publications outline the following important points:
- ARRC prefers a paced transition versus a big bang plan. That means that legacy trades referencing USD LIBOR should continue to exist under their current contractual terms until such time as they mature or are closed out or the counterparties involved collectively want to renegotiate the terms of their agreements.
- ARRC recognizes the transition will take several years to accomplish. The committee does not yet have an exact timeline, but market participants believe the transition will take four to five years.
- ARRC recognizes that absent regulatory encouragement or mandate, participants will not be incented to contribute to USD LIBOR panels if bank LIBOR borrowings erode further (since banks incur potential legal risks in doing so and receive no direct benefits). Therefore, for the time being, the administrator (ICE) would continue to produce LIBOR on its current basis. We will not know if ARRC will use efforts to force ICE to discontinue the administration and publication of LIBOR at some point in the future.
- If LIBOR continues as an alternative reference rate, and given the vast number of USD contracts tied to this rate (estimated at over USD350 trillion), there is a risk that OBFR will not succeed as a replacement reference rate. This remains an important risk to ARRC’s transition plan.
- ARRC recognizes that end users will not choose or transition to OBFR unless there exists a certain threshold level of liquidity. Accordingly, ARRC will be focusing on formulating a transition strategy that will provide this threshold level of liquidity. ARRC is expected to make this strategy public by end of 2017.
Impact on Community Banks
The important question for community banks is whether during the transition period banks would be permitted to retain LIBOR as a reference rate, be required to amend contracts to reference an alternative rate without economic impact (market, legal and documentation costs), or be allowed to amend the definition of LIBOR through a specific grandfathering protocol. The answer to these questions is currently unclear but should become more evident in ARRC’s transition paper to be released.
Some traders that we have spoken to doubt that the new reference rate will supplant LIBOR, others believe that the transition may not succeed at all and still, others believe that the transition may take much longer than five years.
There is not much community banks can currently do to transition existing or new contracts to a new reference rate. However, ARRC is expected to fully outline its paced transition strategy by end of 2017. Assuming that strategy is sufficiently clear and robust, community banks could then start planning the appropriate language, and transition triggers into their loans, deposits and derivative contracts.
Submitted by Chris Nichols on July 31, 2017