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[NEW YORK] A US Treasury Department official said on Thursday it is critical for financial markets to make plans for a transition to an alternative reference rate to Libor, the London interbank offered rate, because of its flaws.
The Alternative Reference Rate Committee, which the Federal Reserve convened in 2014, has identified two possible alternatives to Libor.
The candidates are the Overnight Bank Funding Rate published by the New York Federal Reserve or OBFR and an overnight interest rate under development based on repurchase agreements backed by Treasury securities as general collateral (GC) called the Treasury GC repo-based.
"We believe a transition to an alternative reference rate, which may involve short-term costs, is clearly in our collective interest for financial institutions, market participants, consumers, policymakers, and the general public," Daleep Singh, acting assistant secretary for financial markets at the US Treasury, said in prepared remarks.
Mr Singh spoke at the Futures Industry Association's annual futures and options expo in Chicago.
Libor, which was created by the British Bankers Association in 1986, is referenced for interest payments on about US$350 trillion in notional value of derivative contracts and at least US$10 trillion in loans.
Libor's reputation was tarnished after authorities found in 2012 some banks were manipulating it.
However, there has been resistance to switching to another reference rate due to potential differences with Libor and record-keeping costs, analysts said.
The Libor alternatives under consideration are derived from actual trades in the secured funding market. They are closer to a "risk-free" rate than Libor, which is seen as a measure of credit risk in the banking system, according to Mr Singh.
While measures were implemented in 2014 to avoid Libor manipulation, it is still a flawed for corporate treasurers, pension funds and insurance companies, Mr Singh said.
For corporate treasurers, swapping fixed-rate payments into floating-rate payments may be more expensive because the market has begun to view certain banks as less creditworthy, which can increase Libor, he said.
For pensions and insurers, hedges using Libor-linked derivatives may go up due to worries about a bank default even if traders expect short-term interest rates to fall, he said.
"While Libor risks may not feel urgent now, the best time to transition is before any problems with Libor reach a critical point. A disorderly transition, especially if it happened during a period of broadly elevated stress, would surely be more costly and disruptive for everyone," he said.