The Federal Reserve Bank this week began publishing a new interest rate benchmark that underpins trillions of dollars in financial products, from mortgages to car loans. With the potential expiration in 2021 of LIBOR, the ubiquitous benchmark that has been a mainstay for nearly 50 years, focus is shifting to creating new—and hopefully better—benchmarks that will meet the needs of the financial community while reducing the opportunity for manipulation.
The University of Chicago Law School and the American Financial Exchange recently convened leading figures in law and economics and international finance to discuss how the new benchmark will affect rate-setting by banks, mortgage lenders, credit cards companies and other financial institutions—and the impact on hundreds of millions of consumers. The topic is of special importance to scholars of law and economics—a field born at the University of Chicago Law School that has transformed nearly every area of law.
“Our faculty is known for asking fundamental and important questions,” said Thomas J. Miles, dean of the Law School. “This conference is an example of that because it asks fundamental and important questions about our financial system: Namely, what is the true cost of money? Who should determine that cost? And how should they determine it?”
The Law School’s Coase-Sandor Institute of Law and Economics co-sponsored the April 3 symposium to begin a discussion on the transition to LIBOR alternatives being introduced. SOFR, the Secured Overnight Financial Rate designed by the Alternative Reference Rate Committee, is an overnight secured lending rate based on the U.S. Treasury repurchase agreement market; it was published by the New York Fed for the first time on April 3. Ameribor, created by the American Financial Exchange, reflects the borrowing costs of US small-and mid-sized banks using a 30-day rolling average of the weighted average daily volume in the AFX overnight unsecured market. Two years ago when AFX started, it was trading $5 million and $10 million a day with six participating banks. Today, it has 83 member institutions and has traded as much as $780 million in a single day.
“With contracts tied to LIBOR that are valued at hundreds of trillions of dollars, practitioners need to prepare for this change in the reference rate to minimize its disruption to the financial markets and ensure an orderly transition," said Richard Sandor, CEO of AFX and the Aaron Director Lecturer in Law and Economics at the University of Chicago Law School. “We need to understand what the potential transition to SOFR and Ameribor means.”
While dissatisfaction with LIBOR has been linked to scandals of manipulation that surfaced during the financial crisis, the main impetus for change is LIBOR’s instability and lack of underlying transactions, according to David Bowman, special adviser to the Federal Reserve Board and the conference’s keynote speaker.
“LIBOR is based on markets that are not robust. That means you have to rely on the expert judgment of the panel banks, and most of them on most days don’t report a value of LIBOR that is based on any transactions from that day. Rather, they base their submissions on their expert judgement of what they could have borrowed at that day,” Bowman explained.
Recently two banks left the US dollar panel, and others are questioning their willingness to continue to participate, raising the specter that LIBOR may not exist past 2021.
The impact would be enormous. About $200 trillion worth of financial contracts are written on LIBOR, of which 95 percent are derivatives and about $10 trillion are cash products. None of these contracts include language to deal with the end of LIBOR.
—Prof. Jacqueline Stewart
