(Extract from page 33 of BIS Quarterly Review, March 2019)
This is not the first time a major shift towards a fundamentally different set of reference rates has taken place in the financial system. However, in contrast to earlier examples of "benchmark tipping", the ongoing reform process is a public-private effort to shift away from unsecured interbank rates towards near risk-free benchmarks.
This contrasts with the market-driven process from the late 1980s to the early 1990s of shifting away from risk-free reference rates based on US Treasury bill rates towards benchmarks that embed credit risk based on IBORs. Ironically, back then, market participants transitioned away from using risk-free benchmarks to the risky ones based on eurodollar rates. Banks seeking to manage asset-liability mismatches found the latter a much closer approximation to their actual borrowing costs and lending rates. Otherwise, hedging, say, a portfolio of privately issued securities with a short position in T-bill futures exposed dealers to so-called basis risk, as reflected in a widening TED spread.
LIBOR emerged in the late 1960s to support the burgeoning syndicated loan market. In 1986, the British Bankers' Association (BBA) assumed control of the rate, taking responsibility for its publication until January 2014. The BBA collected interbank offered rate quotes from a panel of banks, reflecting the rates at which banks said they could borrow funds from other banks, just prior to 11:00 local time. The top and bottom four responses were discarded in computing LIBOR as an interquartile trimmed mean of the submissions. At one point, the BBA was computing LIBOR for 10 currencies. By October 2013, that number had dropped to five: the US dollar, euro, sterling, yen and Swiss franc. Some central banks have also relied on LIBOR for their operational policy targets (most notably the Swiss National Bank). Following the cases of LIBOR misconduct, in June 2012 the UK Treasury commissioned Martin Wheatley, then CEO-designate of the Financial Conduct Authority (FCA), to establish an independent review into the setting and usage of LIBOR. The findings, along with a plan for the reform of the benchmark, were published in September 2012 in the Wheatley Review. In April 2013, the FCA was given responsibility for regulating LIBOR, while a new private organisation, the Intercontinental Exchange (ICE) Benchmark Administration Limited (IBA), began to administer ICE LIBOR starting in February 2014, following a tender process.
A number of official bodies have steered the reform process since then. In February 2013, the G20 tasked the Financial Stability Board (FSB) with reviewing and reforming major reference rates. To take the work forward, the FSB commissioned an Official Sector Steering Group (OSSG) to monitor and oversee the efforts to implement the reforms. The FSB has convened a Market Participants Group (MPG) to represent private sector interests and address issues that may arise in the implementation and transition (FSB (2014a)). In July 2013, the International Organization of Securities Commissions (IOSCO) published an overarching framework for the principles underlying benchmarks for use in financial markets (IOSCO (2013)). This was followed by the July 2014 publication of FSB proposals on the implementation of the IOSCO principles by benchmark administrators as the starting point for robust reference rates (FSB (2014b)). The FSB continues to monitor and report on progress (eg FSB (2018)). Since then, various new committees and working groups comprising the official and private sectors have sought to establish viable alternative RFRs. Central banks have taken a lead role in the reforms, both as convenors of the committees or working groups tasked with identifying the new RFRs, and as benchmark administrators. This is largely because reference rates have the character of public goods. Further, the private sector faces coordination challenges while central banks have a long history of producing such measures due to their importance in policymaking (Dudley (2018)).
LIBOR has a host of cousins across currency areas and jurisdictions. As the dominant euro benchmark, EURIBOR was the second most widely used benchmark next to LIBOR. Other financial centres such as Hong Kong SAR, Mumbai, Singapore, Sydney, Tokyo and Toronto featured their own fixings in HIBOR, MIBOR, SIBOR, the bank bill swap rate (BBSW), TIBOR and CDOR, respectively. Overall, there were at least 13 similar poll- or quote-based IBOR-style benchmarks. Notably, several jurisdictions with their own IBORs have opted to reform and retain these rates, where reform was deemed feasible. In these cases, a credit-sensitive term benchmark will coexist with the local currency RFR.
The reforms of credit-sensitive term benchmarks also aim to bring them into compliance with IOSCO principles by rooting them as far as possible in transactions or executable quotes, subjecting them to stricter oversight, and broadening the set of counterparties to include borrowing from non-banks.
McCauley (2001) referred to this process as "benchmark tipping", defined as a strategic situation in which the benefits of a given benchmark choice to one player depend in a positive manner on a similar choice by other players. Currency areas that have opted for such an approach include Australia, Canada and Japan, where reformed editions of the BSSW, CDOR and TIBOR will continue to exist. Meanwhile, attempts to reform EURIBOR are still in flux (EMMI (2019)).