The world’s most important reference index, LIBOR, setting the price for $350 trillion in loans, credit and derivative securities, is being phased out by 2021. UK’s Financial Conduct Authority which regulates Libor, said the index would be phased out and that work would begin for a transition to alternate, and still undetermined, benchmarks by the end of 2021.
The Federal Reserve has already been gearing up for the replacement: last month the Alternative Reference Rates Committee, a group made up of the largest US banks, voted to use a benchmark based on short-term loans known as repurchase agreements or “repo” trades, backed by Treasury securities, to replace U.S. dollar Libor. The new rate is expected to be phased in starting next year, and the group will hold its inaugural meeting in just days, on August 1.
For reference, here is a chart of several short-term rates including the doomed LIBOR 1 month, The Fed Funds Target rate, the EFFECTIVE Fed Funds rate and the USD 1 Month GC Govt Repo rate. In this chart, you can see the problem with LIBOR during the financial crisis.
The last five year track record for several short rate measure illustrates the potential problem with replacing LIBOR with another index. Obviously, The Fed Funds Target Rate has little volatility. The Effective Fed Funds rate is noisy. LIBOR 1 Month is out. Perhaps the Repo rate (the discount interest rate at which a central bank or bank repurchases government securities) is one candidate.
The problem is that the 1 month Reverse Repo rate is more volatile than 1 month LIBOR. And notice in the first chart that Repo (or Reverse Repo) rates had some unsmooth readings on the downside (where LIBOR had some unsmooth readings on the upside).
Since millions of dollars of adjustable-rate mortgages (and CMOs) are indexed to LIBOR, this should represent an interesting transition.