(Reuters) - A committee of large international banks on Thursday voted to adopt an interest rate benchmark from the U.S. Treasuries-backed repurchase agreement market (repo) as an alternative to the use of Libor in around $150 trillion worth of derivatives.
The Alternative Reference Rates Committee (ARRC) was tasked with selecting a new rate at the behest of regulators including the Federal Reserve who worried that a decline in short-term bank lending since the 2008 financial crisis undermined faith in Libor, and posed risks to the trillions of dollars of derivatives backed by the rate.
The repo rate was selected over the Overnight Bank Funding Rate (OBFR), an unsecured bank lending rate based on transactions in the federal funds and Eurodollar markets.
The ARRC said that the repo was considered the most appropriate rate after considering the depth and robustness of the market as well as other factors including regulatory principles.
“I am confident the new reference rate chosen today by the Alternative Reference Rates Committee is based on a deep and actively traded market and will be highly robust,” Federal Reserve Board Governor Jerome Powell said in a statement.
“With this choice, the ARRC has taken another step in addressing the risks involved with LIBOR,” Powell said.
Reforms to banking and money market fund regulations, along with allegations of Libor manipulation before and during the crisis, has resulted in fewer interbank short-term loans and reduced funds’ demand for bank debt, so Libor rates are sometimes estimated rather than based on actual transactions.
Selecting repo “is keeping with a rate that should be broadly reflective of actual transactions,” said Gennadiy Goldberg, an interest rate strategist at TD Securities in New York.
An advantage of repo is that the market is large and liquid, with over $600 billion in trades estimated to be made overnight. That compares with around $300 billion trades in the markets backing the OBFR.
Trading contracts based on the new rate is expected to begin next year on a voluntary basis, though it will likely take several years to build strong liquidity in the product.
“This is the first step in a very long progression away from Libor,” Goldberg said.
Over time, the new benchmark may be adopted for broad use as a reference rate for corporate loans, residential mortgages and credit cards as Libor has been.
The growth of interest rate derivatives since the 1980s made it easier to hedge Libor-based loans, helping spread the use of the rate to a wide range of institutional and consumer loans.
Editing by Sandra Maler