LIBOR is an interest rate benchmark used as a reference rate. This reference rate reflects the general cost of large banks’ borrowing that is not backed by collateral. U.S. dollar LIBOR plays a central role in the U.S. financial markets and economy. It is used to set interest rates on financial products such as mortgages and private student loans.
The difference between LIBOR, formerly known as the London Interbank Offered Rate and now ICE LIBOR (Intercontinental Exchange LIBOR), and benchmark rates that reflect minimal credit risk is used as a measure of risk in banks and stress in financial markets.
During the financial crisis, some banks attempted to manipulate LIBOR to increase returns on their derivatives positions and hide their risks. Also, after the crisis, transaction volumes in LIBOR dwindled. As a result, confidence in this reference rate dropped. The thin and declining base of transactions underpinning LIBOR led to calls for reform in the United States and abroad.
The Federal Reserve Board and the Federal Reserve Bank of New York convened the Alternative Reference Rates Committee (ARRC) to identify an alternative to LIBOR. The OFR, a member of ARRC, collaborated with the Federal Reserve and the Federal Reserve Bank of New York to develop three new rates. In June 2017, the ARRC selected one of these rates, the Secured Overnight Financing Rate (SOFR), as its recommended alternative to U.S. dollar LIBOR.
The SOFR is based on repo interest rates. A repo, or repurchase agreement, is a secured loan; one party sells a security to another party and agrees to repurchase it later at a set date and price. Because repos are a key source of short-term funding in the financial system, a rate based on these transactions is a good candidate for an alternative reference rate.
The SOFR will include overnight, Treasury-backed repo transactions that take place in the Bank of New York Mellon’s triparty repo system or are cleared through one of two Fixed Income Clearing Corporation platforms: (1) the Delivery-Versus-Payment Repo Service and (2) the General Collateral Finance (GCF) Repo Service.
In February 2019, the OFR adopted a rule to establish a data collection covering centrally cleared funding transactions in the U.S. repo market. Data from the collection will be used to enhance the production of the SOFR.
Prior to the ARRC’s work, the OFR collaborated with the Federal Reserve and the Securities and Exchange Commission in 2015 to conduct a voluntary pilot project to explore how to collect data about bilateral repo agreements.
The transition to a new reference rate will require broad acceptance by the financial markets. Collaboration between industry and government will be key to a smooth and fast transition. The OFR is involved in the planning for the alternative reference rate and is playing a role in its implementation.
Director’s related blog: Time is Right for LIBOR Alternative (12/08/2016)
FEDS Notes article: The Cleared Bilateral Repo Market and Proposed Repo Benchmark Rates (2/27/2017)
ARRC press release: https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2017/ARRC-press-release-Jun-22-2017.pdf (6/22/2017)
Federal Reserve Notice and Request for Comment: https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20170824a1.pdf (8/24/2017)