By Karen Brettell
April 3 (Reuters) - The New York Federal Reserve will launch a benchmark U.S. rate on Tuesday to potentially replace Libor, and market participants hope it will prove more reliable after a long and complex switchover.
The New York Fed will begin publishing the Secured Overnight Financing Rate (SOFR), the first step in a multi-year plan to transition more derivatives away from the London interbank offered rate (Libor), which regulators say poses systemic risks if it ceases publication.
Analysts have struggled to explain a recent jump in Libor, which has reached nine-year highs even as bank credit quality is seen as solid.
Increased short-term Treasury issuance and declining demand for credit due to tax reforms are deemed the most likely factors. A decline in interbank lending has reduced the robustness of the rate, which is sometimes estimated rather than based on actual transactions.
SOFR is based on the overnight Treasury repurchase agreement market, which trades around $800 billion in volume daily.
“It’s going to be based on a very, very robust set of transactions. I don’t think a lot of the issues and unknown volatility around Libor is going to exist,” said Blake Gwinn, an interest rate strategist at NatWest Markets in Stamford, Connecticut.
“Instances like what we’ve been going through this past month where it’s not even a clear cut bank credit issue or a dollar funding issue per se. It’s kind of got everybody scratching their heads trying to figure out why it’s doing what it’s doing,” Gwinn said.
A move away from Libor, however, is expected to be gradual and complicated.
One issue is that there is not yet a market for term loans such as one and three months, as in Libor.
“It’s hard to imagine a way they could come up with a similar calculation for a term rate and that’s the big difference between whether or not people would be comfortable adopting SOFR as a straight replacement for Libor,” said Thomas Simons, a money market economist at Jefferies in New York.
It will take time to develop liquidity in derivatives based on the rate. The CME Group will launch futures trades based on SOFR on May 7, while major dealers will enable swaps trading on the rate this year.
Investors will also need to adjust to the day to day volatility of the repurchase market, where rates typically increase ahead of monthly and quarterly closings.
“A lot of folks have not really followed the repo market and some of the intramonth variations particularly closely,” said Brian Cabana, head of short rates strategy at Bank of America Merrill Lynch in New York.
“On a day to day basis it will be more volatile, but smoothing out over a three month time horizon it should be similarly volatile,” Cabana said. (Reporting by Karen Brettell Editing by Tom Brown)