This Is The Index That's Supposed To Replace LIBOR

Tracy Alloway (0:10)

Hello, and welcome to another episode of the Odd Lots Podcast. I'm Tracy Alloway.

Joe Weisenthal (0:15)

And I'm Joe Weisenthal.

Tracy Alloway (0:17)

So Joe, we are on part two of our Epic LIBOR series.

Joe Weisenthal (0:23)

Yeah, I'm very excited about this series. I always learn a lot from doing these podcasts with you, but this is one area that I know is a incredibly important to the way the financial system works, LIBOR, and the transition away from it, and also an area that I don't know nearly enough. So I'm very excited that we are moving on to part two of this year.

Tracy Alloway (0:51)

Yeah, and just as a reminder, if you haven't listened to the first episode, you definitely should.

But we basically spoke about everything that went wrong with LIBOR sort of pre and post financial crisis. So just as a quick reminder, there was a huge LIBOR scandal. The idea of having banks submit the reference rate for basically an unsecured loan that would be made between dealer banks was really thrown into doubt. And Q, or fast forward to where we are today, and there's a huge effort underway to try to replace LIBOR with a brand new reference rate.

Joe Weisenthal (1:31)

Right, and just, I mean, I assume everyone should have listened to the first episode, but just a reminder, why we care in part is because so many financial contracts, derivatives, loans, et cetera, are priced in some way off this singular reference rate. And so when it was sort of everyone realized that the old one had flaws in terms of how it was constructed and it was open to manipulation and so forth, there is now the effort underway to get all these contracts and debts and everything else to price around a new singular standard.

Tracy Alloway (2:07)

Yeah, so in this particular episode, we're gonna focus on what that new reference rate is. And we have really the perfect person to talk about it. Someone who's been covering the short-term dollar funding markets for years now. And I've certainly been reading his research for years. It's Joe Abate, Barclays Analyst.

Joe, thanks so much for coming on the show.

Joseph Abate (2:29)

Thank you.

Tracy Alloway (2:31)

How's the LIBOR transition going? How would you characterize where we actually are at this moment in time?

Joseph Abate (2:38)

I'd say that we're making progress.

Within the last two years, we obviously decided on what kind of benchmark replacement rate to use. I think the challenge at this point is to get people to actually use it. We're seeing developments in futures markets and term rates that reference this. We've seen people start to issue off of the rate itself, but this is still relatively speaking, early days in the process. We need to see volumes in particular in a number of different sectors, whether it's issuing front in terms of borrowing, whether it's in terms of hedging. We need to see that activity pick up at this point. So I'd say early days, but hopefully optimistic.

Joe Weisenthal (3:36)

So just to back up for a second, we know that after it was sort of agreed upon that LIBOR couldn't be sustained, what are the regulatory demands and from whom were these regulatory demands made on the financial system to find and develop a new reference rate?

Joseph Abate (3:58)

So pretty much it was a global effort, but largely it came from out of the UK where they were regulating, the PRA was regulating the LIBOR. And obviously they had done the work in terms of identifying the deficiencies in the unsecured rate.

And so, they were leading the effort. It was adopted by the Federal Reserve, I think back in 2014, and the Fed effectively convened a committee called the Alternative Reference Rate Committee, which then began work to find an alternative reference rate. And then once that reference rate was decided, the Alternative Reference Rate Committee would move to kind of the adoption phase, right? So speaking to end users, if you will, to get them to start using the new rate. So it's been a, to your point, it's been a multi, multi-year process begun with regulators.

Tracy Alloway (5:07)

So the alternative reference rate that they eventually settled on, and we spoke a little bit about this in the first episode, but it's something called the Secured Overnight Financing Rate, or SOFR, SOFR.

How did they settle on that one? And what, in your view, is the key difference between it and the predecessor LIBOR?

Joseph Abate (5:30)

They essentially gave the Alternative Reference Rate Committee marching orders and told them, you know, find a replacement rate. It must be based on a transparent liquid and deep market so that you wouldn't have a submission process, as is the case with LIBOR.