Monetary Policy & Inflation | Rates
The repo market flash crash certainly raised awareness of the fragile nature of money markets and market plumbing. Yet curiously no one seems to be concerned that the repo market is slated to be the new money market benchmark in coming years if as expected LIBOR is phased out.
Then again, most people outside of the insular money market world are hardly aware of this. And regulators and market participants are so far down the road with this project that there is little chance of its being derailed at this point. But it might not be a cut-and-dry closed issue either. Ultimately markets will have the final say.
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The repo market flash crash certainly raised awareness of the fragile nature of money markets and market plumbing. Yet curiously no one seems to be concerned that the repo market is slated to be the new money market benchmark in coming years if as expected LIBOR is phased out.
Then again, most people outside of the insular money market world are hardly aware of this. And regulators and market participants are so far down the road with this project that there is little chance of its being derailed at this point. But it might not be a cut-and-dry closed issue either. Ultimately markets will have the final say.
A Bit of Background
For decades the primary benchmark for money markets has been LIBOR. Today it is the reference rate for some $200 trillion dollars of financial contracts, of which more than 90% are derivatives and remainder various loans, mortgages and securities.
LIBOR represents the rate at which banks make unsecured short-term loans to each other. It is “fixed” daily through a survey of major banks for rates on loans ranging from overnight to 12 months.
Since the financial crisis LIBOR has become more problematic. In a world where quantitative easing has left banks swimming in excess reserves interbank lending has dried up. A lending market that once handled hundreds of billion dollars daily has shriveled to billions if that. As a result, the daily LIBOR fix relies more on expert judgement than actual transactions. In addition, LIBOR was prone to manipulation during and after the financial crisis by traders who tried to nudge the rate slightly higher or lower to better match their positions.
Those problems have been cleaned up, but there remains the prospect that in coming years fewer banks will submit LIBOR levels if it boils down to little more than educated guesses.
Over the past six years market participants and regulators have worked to identify and develop new benchmarks to replace LIBOR and its various xIBOR relatives around the world.
In the US authorities have settled on the Secured Overnight Financing Rate. The goal was to develop something that is market- and transaction-based, and not reliant on “expert” judgment. Accordingly, SOFR is based on the overnight repo market where daily transaction activity is more than a trillion dollars a day. The Federal Reserve Bank of New York calculates it daily based on the volume-weighted median of rates in the tri-party repo market and bilateral Treasury repo transactions.
A Closer Look
The NY Fed has been publishing SOFR since April 2018:
Chart 1: SOFR Is Indeed Market Based!
Source: Bloomberg, Macro Hive
The overnight repo market may be very deep but compared to overnight LIBOR SOFR is very noisy – and that’s based on data from before the flash crash. Alas, this market is subject to various supply and demand technical pressures, especially around month- and quarter-end.
To get around this problem the relatively few financial contracts that reference SOFR use moving averages of the daily SOFR:
Chart 2: Smoothed SOFR Is Backward Looking
Source: Bloomberg, Macro Hive
It is immediately apparent that smoothed SOFR is backward looking and still a bit noisy. To state the obvious, this fix obviates the whole point of moving to a market- and transaction-based index.
What Does the Market Require of an Index or Benchmark?
Among key points, it should be stable, reflective of current economic fundamentals, and forward looking if possible. Market participants can then bring their judgment to the table to determine the spread over the index that is appropriate for a given transaction. An index that is subject to the kinds of technical pressures that affect SOFR and that lags the market on a smoothed basis almost by definition will cloud the market’s ability to assign appropriate risk premiums.
Let’s acknowledge the obvious. The current SOFR is not a pure transaction-based index (as it is a composite of several different inputs).Smoothed variants are not market-based. And finally, if as appears likely, the flash crash causes the Fed to create a backstop to ensure ongoing liquidity and stability in the repo market, SOFR will become a defacto administered rate rather than a market-based rate.
That opens the door to a variety of other indices that also aren’t purely transaction-based, but that are market-based.
Consider, for example, interest on excess reserves, the rate that the Fed pays on excess reserves. Another possibility is the constant maturity Treasury indices that the Fed calculates daily based on market prices. Or, a term structure of short-term rates could be based on T-bill rates. The Treasury could start an overnight T-bill program if need be.
Yes, these are government borrowing rates that are unavailable to the public at large. But they could meet the needs of the market without the complexities of SOFR. Another point to consider: SOFR is strictly an overnight rate. But the market will need a term structure of SOFR rates. It is hoped that a futures market will develop in term SOFR. But those futures prices have to implicitly reference something and the primary reference points will have to be one of the indices/rates above.
LIBOR may have outlived its usefulness. But in their headlong rush to be academic purists and create the perfect transaction-based overnight index authorities have clearly lost sight of what the market requires of a benchmark.
To date the market has been slow to switch from LIBOR to SOFR although uptake has been picking up. It will be interesting to see whether the flash crash causes investors and traders to pull back and rethink SOFR.
Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.