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P2.T10.20.7. Beyond LIBOR

Nicole Seaman

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Learning objectives: Describe the features comprising an ideal benchmark. Examine the issues that led to the replacement of LIBOR as the reference rate. Examine the risks inherent in basing risk-free rates (RFR’s) on transactions in the repo market


20.7.1. According to the Bank for International Settlements (BIS)(†), the ideal reference rate has three features. Each of the following is true as a desirable feature of a reference rate EXCEPT which is false?

a. The rate is accurate because it is not susceptible to manipulation
b. The rate should be stable; specifically, the rate should not be more volatile than its associated policy rate
c. The rate serves as a reference (and discount) rate beyond money markets to include instruments with longer tenors
d. The rate serves as a reference for both term lending and borrowing (aka, funding) costs

20.7.2. Despite the dominance of interbank offered rates (IBORs) including and especially the London interbank offered rate (LIBOR), according to BIS(†), "there is currently considerable momentum for transitioning away from LIBOR benchmarks." Each of the following is a reason (or cause) for replacement of LIBOR as a reference rate EXCEPT which is false?

a. The dramatic increase in interbank deposit market activity
b. The increased dispersion of individual bank credit risk
c. Banks have shifted their funding mix toward sources with less credit risk
d. LIBOR is constructed by a small survey of reported, non-binding quotes rather than actual transactions

20.7.3. According to the Bank for International Settlements (BIS)(†), five of the largest currency areas have moved to an overnight benchmark. These new risk-free rates (RFRs) include SOFR (secured overnight financing rate) in the United States; SONIA (sterling overnight index average) in the United Kingdom; ESTER (euro short-term rate) in the Euro area; SARON (Swiss average overnight rate) in Switzerland; and TONA (Tokyo overnight average rate) in Japan. Which of the following is an inherent risk in basing the risk-free rate on SOFR (best answer, please)?

a. SOFR is neither transaction-based nor does it reflect borrowing costs from wholesale non-bank counterparties
b. SOFR exhibits a spread relative to the effective federal funds rate (EFFR) just as other RFRs exhibit spreads relative to their key policy rates which render monetary policy ineffective
c. When there is a glut (aka, oversupply) of Treasury bonds, which are used as repo collateral, the SOFR tends to spike; i.e., sudden widening of spread between SOFR and EFFR
d. During flight-to-quality episodes (e.g., 2016 and 2017), an increased demand for Treasures widens the spread between SOFR and EFFR as SOFR temporarily spikes to artificially high levels

Answers here:

(†) Question refers to Andreas Schrimpf and Vladyslav Sushko, “Beyond LIBOR: a primer on the new benchmark rates,” BIS Quarterly Review, March 5, 2019.