LIBOR alternatives in a post-scandal world

The London Inter-bank Offered Rate (LIBOR) is the benchmark for 350 trillion of financial instruments around the world, but the 2008 financial crisis highlighted its vulnerability to manipulation.

This was written for Bloomberg Professional Services by Michael McDonough, Chief Economist for Financial Products and Head of Bloomberg’s Central Bank and Government Financial Agency Business, and Chukwudi Ugwu , IFC-Milken Fellow.

With LIBOR now scheduled to be phased out in 2021, regulators are racing to find suitable alternatives.

In the U.S., the Federal Reserve’s Alternative Rate Reference Committee—setup to explore LIBOR alternatives—created a new benchmark rate Secured Overnight Financing Rate (SOFR). The New York Federal Reserve began publishing SOFR data last April and while the benchmark has coming a long

over a short-period of time, further development is needed before it can be positioned to replace LIBOR in 2021.

Challenges include building more liquidity in the product, and while volume in SOFR futures is rising, it remains well below similar alternatives including Fed Funds and euro dollar futures. At most, SOFR currently represents about 2% of the euro dollar futures daily trading volume. Though by

comparison when launched, it took Fed Fund Futures five years achieve a daily average trading volume of 20,000 contracts, SOFR achieved this level in just eight months. An official announcement that LIBOR will cease to exist at the end of 2021 would likely help drive an even more substantial increase in SOFR volumes.

Solutions across Europe differ by country. In the U.K., the Bank of England’s Working Group on Sterling Risk-Free Reference Rates is planning to transition to the Sterling Overnight Index Average (SONIA) as the new benchmark. Last year, the European Central Bank’s working group agreed to develop a new euro short-term rate (ESTER) to use as its

benchmark. ESTER is designed to mimic the wholesale euro unsecured overnight borrowing costs of euro area banks leveraging data already accessible within the Eurosystem. The ECB plans to start publishing Ester rates in October.

For more detailed analysis on this topic please reference our January 31, 2019 Central Bank and Supranational Webinar Series, “Ten Years After the Scandals: LIBOR Replacements”. In the webinar, Christian Miller, the head of Bloomberg’s rate market specialist team, discusses the ongoing developments in the SOFR market, while EMEA central bank specialist, Natalia Hencsey, addresses European developments and how they

compare to the U.S. The webinar was hosted by Michael McDonough, chief economist for financial products and head of our central bank and government financial agency business.