CME Group is closely engaged with several financial industry efforts to examine LIBOR’s long-established role as one of the world’s most important interest rate benchmarks. This includes participation on the Alternative Reference Rate Committee (ARRC), which was convened by the Federal Reserve in late 2014 to identify an alternative US dollar interest rate benchmark that would be based more firmly on market transaction data. After more than two years of study and deliberation, ARRC announced last June that it has endorsed the Secured Overnight Funding Rate (SOFR), a broad Treasuries repo financing rate, to be published by the Federal Reserve Bank of New York and the Office of Financial Research starting in early 2018, as the interest rate benchmark that, in ARRC’s collective view, represents best practice for use in connection with US dollar derivatives and other financial contracts.
CME has shared several updates on this activity through e-mail correspondence with market participants and through its monthly newsletter, The Rates Recap. These updates included the ARRC Interim Report (May 2016)1 and ARRC’s June announcement of its choice of alternative interest rate benchmark.2 Most recently, on July 26, CME publicized its intention to launch futures and options based on SOFR.3
The following day Andrew Bailey, the chief executive of the UK Financial Conduct Authority (FCA), delivered a watershed policy statement on the future of LIBOR, specifically that panel banks’ submissions to LIBOR after 2021 would be voluntary.4 When considering the importance of Bailey’s statements, it’s worth keeping four points in mind:
- There is no set end date for LIBOR publication
LIBOR relies fundamentally on voluntary submission by each member of a standing panel of contributor banks of the interest rate that the bank pays for unsecured funding at each of several tenors ranging from overnight to 12 months. Bailey announced that the FCA has effectively secured LIBOR’s continuity for the next 4.5 years: The FCA has “spoken to all the current panel banks about agreeing voluntarily to sustain LIBOR … until end-2021…” and “[t]here has been wide support from the panel banks for sustaining LIBOR for this period…”As Bailey acknowledged, if all (or a sufficient quorum) of the 19 contributor banks are amenable to it, then the LIBOR administrator, ICE Benchmark Administration Ltd (IBA), could continue to calculate and publish LIBOR after year-end 2021, even without the FCA’s exercise of its powers of compulsory participation. “An obvious question is what happens to LIBOR after end-2021. And what happens to legacy contracts that still reference LIBOR at that point? The answer to the first question would be up to the benchmark’s administrator – IBA – and the panel banks. They could of course continue to produce LIBOR on its current basis if they wanted to, and were able to do so.” We address the second question in section 4.
- US dollar fixed income market participants may adopt the new interest rate benchmark
The ARRC has recommended SOFR, which will be underpinned by the US Treasury general collateral overnight repurchase (repo) market, for which the pool of eligible transactions is estimated to run typically between $600 billion and $700 billion per day. While LIBOR may continue to exist, the expectation is that market practitioners will follow ARRC’s recommendation and begin using this rate for new transactions, given the involvement in ARRC of the official sector as well as many of the largest participants in the derivatives market.This is among the reasons that CME announced its intention to launch futures and options on this new interest rate benchmark, even before Bailey had shared his thoughts about LIBOR’s future.5 Since 2013, CME has been investigating launching futures contracts on a Treasury repo-based index. Though their dynamics are mutually correlated, LIBOR, the daily effective federal funds rate, and the SOFR benchmark are all mutually financially distinct, and therefore mutually complementary.
CME Group is fully committed to working with market participants to ensure that their risk management needs are met. For this reason, contracts on SOFR will trade in parallel with existing short-term interest rate futures listed on the CME Group exchanges, potentially for a very long time, during which market participants will benefit from both the initial margin offsets among contracts based on these various rates and the inter-commodity spread-trading opportunities among them. We are also committed to preparing OTC Clearing solutions for OIS referencing the new rate, as soon as there is sufficient pricing history and market activity to implement our risk management processes.
- LIBOR has broader implications beyond CME Eurodollar futures
As a prominent LIBOR-reference liquidity pool, CME Eurodollar futures and options remain as strong and reliable as ever. Average daily trading volume exceeds 4.14 million contracts ($4 trillion notional), and open interest is over 50.21 million contracts ($50 trillion notional).6 Market practitioners continue to employ the Eurodollar futures and options product suite widely and frequently as one of their key risk management tools.But it’s worth remembering that an estimated $160 trillion of financial obligations are based on USD Libor, including, e.g., syndicated loans, home mortgages, student loans, retail bank deposits, structured products, OTC interest rate swaps, forward rate agreements, and OTC interbank cross-currency swaps. Of this total, the open interest in CME Eurodollar futures at any given time represents only 20-25%.
- If LIBOR were discontinued, there are several layers of fallback provisions that the industry and CME Group would use for all remaining obligations.
If LIBOR were discontinued, CME Group would use fallbacks for all remaining obligations. Through its participation in the ISDA Benchmark Working Groups that have been formed to codify industry-standard fallback provisions,7 the exchange is fully committed to working with market participants across the sell-side, the buy-side, and the regulatory community to preserve the alignment of CME Eurodollar futures final settlement prices with market-standard approaches for managing resolution of LIBOR-reference obligations.As discussed above, LIBOR will continue to exist through at least 2021, and will likely continue to live beyond that. Among the reasons is that production of LIBOR already has been strengthened by the procedures and standards for compliance and record-keeping now set forth in the ICE LIBOR Code of Conduct, including adherence to a three-tier waterfall of data sources on which each LIBOR submission by a contributor bank must be based.8 Continuity of LIBOR production is protected, moreover, by the contingency measures codified in the ICE LIBOR Reduced Submissions Policy.9
If these and other fallback provisions were exhausted, such that there were an indefinite impairment of a USD LIBOR value, the exchange would be empowered under CME Rule 812 to “establish a final settlement price that reflects the true market value at the time of final settlement.” This would likely be done using the applicable industry-accepted fallback spreads between LIBOR and SOFR. At the same time, it is anticipated that the liquidity pool on SOFR would be highly developed for the market’s interest rate risk management needs.
On Wednesday, October 4, 2017, CME Group hosted a public webinar to further engage market participants on the design of futures and options contracts on the ARRC-endorsed Secured Overnight Funding Rate (SOFR). These contracts are expected to be listed, subject to regulatory review and approval, soon after the Federal Reserve Bank of New York and U.S. Treasury Office of Financial Research start daily publication of the rate in 2018. With LIBOR available at least through 2021, and potentially thereafter as well, it is anticipated that Eurodollar, 30-Day Fed Funds, and SOFR futures and option contracts may coexist for many years, serving the market’s risk management and hedging needs, and providing beneficial margin offsets and inter-commodity spreading opportunities among the three interest rate benchmarks.
1 The Alternative Reference Rates Committee, Interim Report and Consultation, Federal Reserve Bank of New York, May 20, 2016, available at: https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2016/arrc-interim-report-and-consultation.pdf?la=en
2 The Alternative Reference Rates Committee, The ARRC Selects a Broad Repo Rate as its Preferred Alternative Reference Rate, Federal Reserve Bank of New York, May 20, 2016, available at: https://www.newyorkfed.org/medialibrary/microsites/arrc/files/2017/ARRC-press-release-Jun-22-2017.pdf
3 CME Group, CME Group to Develop Derivatives on Broad Treasuries Repo Financing Rate, News Release, June 26, 2017, available at: www.cmegroup.com/media-room/press-releases/2017/7/26/cme_group_to_developderivativesonbroadtreasuriesrepofinancingrat.html
4 Andrew Bailey, The future of LIBOR, speech given at Bloomberg London, Financial Conduct Authority, 27 July 2017, available at: https://www.fca.org.uk/news/speeches/the-future-of-libor
5 CME Group, op cit.
6 Average daily trading volume January 1, 2017, through July 31, 2017. Open interest is as of July 31, 2017.
7 ISDA staff and multiple ISDA Benchmark Working Groups are currently working in conjunction with the Financial Stability Board’s Official Sector Steering Group to improve the robustness of fallback provisions for LIBOR and other key interbank offered rate benchmarks. ISDA has published a number of pieces in regard to this initiative at, eg: http://www2.isda.org/newsroom/webcasts-and-videos/ One of the videos at this URL specifically discusses IBOR fallback definitions.
8 ICE Benchmark Administration Ltd, ICE LIBOR Code of Conduct, available at: https://www.theice.com/publicdocs/ICE_LIBOR_CODE_OF_CONDUCT_CONTRIBUTING_BANKS_20160629.pdf
9 ICE Benchmark Administration Ltd, ICE LIBOR Reduced Submissions Policy, available at: https://www.theice.com/publicdocs/ICE_LIBOR_Reduced_Submissions_Policy.pdf