The Benchmark Set to Replace Libor Is Acting Weird
February 11 2019 - 08:29AM
Dow Jones News
By Daniel Kruger and Telis Demos
Recent volatility in the market for overnight cash loans is
raising concerns about a new benchmark that could set interest
rates for trillions of dollars in mortgages and corporate debt.
The cost to borrow cash overnight spiked late last year in part
of the market for repurchase agreements, where lenders such as
money-market funds make short-term loans to bond brokers, often
using government debt as collateral. The "repo" rate topped out
above 6% in intraday trading on Dec. 31 before settling at an
all-time high of 5.149%, according to JPMorgan.
That has investors and bankers paying close attention to
developments in this obscure yet vital part of the debt market,
because repo trades are a key component of a new borrowing
benchmark designed by the Federal Reserve Bank of New York. That
benchmark, called SOFR, for the secured overnight financing rate,
is considered the leading candidate to replace the fading London
interbank offered rate, currently used in setting interest rates on
hundreds of trillions in debt.
On Dec. 31, SOFR jumped from 2.46% the day before to 3%, at the
time the highest level since the Federal Reserve began publishing
the benchmark last April.
Libor for many years was closely watched as a benchmark for
lending and as a measure of stress in the banking system. Its surge
versus other borrowing rates in late 2008 spurred investors' fears
as the financial crisis accelerated.
But it was discredited after evidence emerged that bank traders
were manipulating Libor in order to make trading profits. Banks
were fined billions of dollars, and several traders were sent to
prison. Since 2012, Libor has been under the supervision of U.K.
regulators and is expected to expire at the end of 2021.
If SOFR proves unusually volatile or hard to predict, it would
diminish the benchmark's appeal to companies that are considering
tying their borrowing costs to it, adding uncertainty to the
market's search for a suitable Libor alternative.
The supply of securities that are used for collateral in the
repo market has grown as the Treasury has increased its sales of
short-term debt to help fund rising budget deficits. At the same
time, demand for the securities has increased after the banking
industry's central clearinghouse for bonds, the Fixed Income
Clearing Corp., began allowing banks to sponsor hedge funds as
direct participants in repo trading.
The repo market "is absolutely an indispensable grease and
catalyst to the smooth functioning of other markets," said Glenn
Havlicek, a former banker who is now chief executive of GLMX, a
technology company that is providing tools to repo trading firms,
with the aim of making it easier to transact and report pricing.
"But it was never anticipated for prime time. There are definitely
growing pains."
Volatility in the repo market could pose problems for the banks
and investment firms that have united to support the adoption of
SOFR as a replacement for Libor.
The three-month dollar Libor rate, the most widely used
variable-rate benchmark, which is used in financial contracts
valued at roughly $200 trillion, according to the Fed, is based on
an estimate of what banks would pay to borrow for that period, and
is set at the time of the loan, resetting every three months.
The three-month SOFR rate is calculated using overnight yields
during the period, so the rate isn't known until the cumulative
yields have been compounded. This method exposes borrowers and
lenders using SOFR to market volatility, as yields in the repo
market can move along with the yields on short-term Treasurys.
Repurchase agreements typically are subject to rises in
volatility at the ends of months, quarters and years or at other
periods where cash is in demand. Some analysts expect volatility to
rise toward the end of this month, when the U.S. debt ceiling could
limit the Treasury's ability to sell short-term bills.
That volatility could make it more difficult for borrowers to
use a benchmark subject to unexpected spikes depending on supply
and demand within the cash market. The repo market has seen trading
volume grow, often rising above $1 trillion a day from about $800
billion a year ago.
Libor has experienced some atypical volatility, as well. On
Thursday, the three-month interbank rate had its biggest one-day
decline since 2009, and analysts had no clear reason to explain the
move.
Banks' unwillingness to add to their year-end positions by
borrowing securities on Dec. 31 may have contributed to a sudden
doubling in the repo rate on that day, analysts said.
Part of the largest banks' regulatory capital requirements are
determined by a snapshot of their holdings on the last day of the
year. As a result, a tiny change in their books could tip them into
a much higher or lower capital-requirement tier for the entire next
year.
"Some banks likely pulled back from the repo market in order to
avoid triggering a higher surcharge and the need to hold additional
capital in 2019," Bank of America Merrill Lynch strategists wrote
in a January note.
Write to Daniel Kruger at Daniel.Kruger@wsj.com and Telis Demos
at telis.demos@wsj.com
(END) Dow Jones Newswires
February 11, 2019 08:14 ET (13:14 GMT)
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