New Regulation and a Redefinition of Libor Collide

The financial markets have become somewhat obsessed with the SEC regulation of money market funds triggering a rise in Libor. The obsession is for good reason: estimates are that Libor benchmarks underlie about $350 trillion in financial contracts. A fundamental shift in Libor is like a disturbance in the force. There has been a lot of terrific research and articles published that focus on the ramifications of the money market fund regulation, but none that I personally have seen yet that include the impact of the recent (March 2016) substantial broadening of the definition of Libor and the Fed’s similarly defined overnight bank funding rate, which they have been tracking since 2014 and recently (March 2016) began publishing. That is what I focus on in this note.

Executive Summary

·         New regulation: The following two controversial and long-debated SEC regulations implementing reform measures on money market funds are set to go into effect in October 14, 2016.

1.       The net asset values (NAVs) or prime institutional money market funds will no longer be held constant at $1, but will float with the market value of the underlying assets.  

2.       Prime money market funds will have the ability to impose “gates” on redemptions for up to 10 days, and assess liquidity fees, if liquid assets fall below a 30% threshold. This will apply to both institutional and retail prime money market funds.

·         Prompts an exit: Not unpredictably – since it was predicted by absolutely everyone – this has resulted in a “rush for the exits” ahead of the October effective date. Since the beginning of 2016 – becoming pronounced in June 2016 - assets in these funds have dropped by roughly $400 billion, from $1.3 trillion to $900 billion, due to a combination of investor redemptions and fund conversions.

·         Raises the cost of commercial paper: Money market funds have been the dominant investor group lending US dollars to both financial and non-financial corporations - heavily foreign-based corporations – via the US commercial paper market. Ninety-day commercial paper rates have risen ~20 bps since late June when the exodus began in earnest, triggering equivalent increases in other short-term wholesale funding rates, e.g. certificates of deposit and eurodollar deposit rates (= Libor).

·         Propagates to other short-term funding markets: A priori one would expect short-term financing rates to be strongly correlated with one another, and typically they are. However, any trader or analyst of short-term interest rates will caution you that the various wholesale funding markets which supply the financing are not necessarily fungible. That’s what we’re witnessing now; e.g. a foreign-based company which raises US dollars by issuing commercial paper cannot easily replace that funding at similar cost by borrowing eurodollars from a US or foreign-based bank on a revolving basis.

·         Exacerbated by central bank and Libor administrators tying these financing sources together: The implementation of these money market reforms has (perhaps inadvertently) coincided with initiatives by the Federal Reserve and the Libor benchmark administrators to:

1.       Broaden the definition of wholesale bank funding rates, including a rewrite of the definition of Libor that became effective in March 2016; and the Federal Reserve’s overnight bank funding (OBF) rate, meant to eventually supplant the fed effective, which the Fed began publishing in March 2016.

2.       Anchor the calculation of the OBF and Libor rates to transactions.

3.       The redefinition of Libor greatly expands the list of counterparties and eligible transactions, directly linking USD Libor not only to eurodollar borrowings, but also to transactions in the commercial paper and certificate of deposit market.   

·         As 3m CP and 3m Libor rates rise in tandem: The massive drawdown of prime money market fund financing has – so far, “modestly” - driven up wholesale US dollar funding rates by approximately 20 bp for financial companies and about 10 bp for non-financials in 90-day commercial paper; a similar amount in 3m certificates of deposit, and  20 bp in 3m Libor.  This has, of course, put upward pressure on Eurodollar futures contract rates, which has in turn contributed to some widening of front-end swap spreads and Libor-OIS spreads.

·         Projection – it’s not finished, and it will be sticky: Expect the rise in wholesale funding costs to be persistent, since it’s due to a regulatory and policy shift, not to a change in credit fundamentals. It also has further to go. Better analysts than myself have predicted ~$600 bn total eventual drawdowns from prime MMFs, which would mean we have about ~$200 bn left to go. That could add at least 10 bps more to 3m Libor, which would top it out based on current levels at ~95-100 bps. Over time, that increase should revert somewhat as CP issuers adapt, restructure and attempt to seek out cheaper financing. But don’t expect the reversion to be substantial.

Background on the interbank lending rates: Eurodollars and Fed Funds

What’s a eurodollar?

A eurodollar, or eurodollar deposit, are US dollar-denominated deposits held at foreign banks or foreign branches of US banks. So $1 million US dollars on deposit at JP Morgan in London, or Deutsche Bank in Frankfurt, or Bank of Tokyo-Mitsubishi in Tokyo are eurodollar deposits. Although the “euro” moniker has remained, eurodollar deposits refer to any US dollar denominated bank deposits held offshore.

Is there a difference between borrowing dollars from foreign banks (eurodollars) versus borrowing them from a US bank (fed funds)?

Yes. There used to be somewhat less of a difference before the definition of Libor was broadened. Now it’s more substantial. This regulatory-induced rate increase has exposed a tiny 2 bp crack. Since the underlying structures of the two markets are beginning to diverge more, if the markets come under significant stress I think you could see larger variances in Libor and OIS rates and increased spread volatility.

The reason is that the federal funds market is still functionally an inter-bank and government-sponsored (GSE) lending market. Daily fed funds trading volume in the post-crisis, post quantitative easing world is comparatively small, at about $65 billion per day. The daily fed effective rate has held almost perfectly steady at 40 bps since late June 2016 – a modest increase of 3 bps from 37 bps, where it had held steady since the last Fed hike in December 2015. By comparison overnight Libor – which is a tiny bit more volatile – has increased rather steadily from 36.6 bps in Jan 2016 to 41.8 bps currently. An increase of 5 bps versus 3 bps would perhaps be insignificant, except the difference propagates forward into longer term rates, and is reflected in widening Libor/OIS spreads.

The GSEs (primarily the Federal Home Loan Banks) are the biggest lenders of funds. The GSEs cannot earn interest on excess reserves (IOER), so they are willing to lend their cash at slightly lower rates than IOER (currently 50 bps). The ultimate fed funds borrowers are typically smaller banks and thrifts – often using a larger bank as intermediary – who are structurally short of funds.

By contrast, the eurodollar market is much more liquid with a larger group of borrowers and lenders.

The following is excerpted from an excellent post, The Eurodollar Market in the United States, on the Liberty Street Economics blog of the Federal Reserve Bank of New York (emphasis added):

Although Eurodollar deposits, by definition, are held by institutions outside the United States, there is an active market for Eurodollar deposits inside the United States, particularly in New York City. U.S. depository institutions and U.S. branches of foreign banks (FBOs), which we will collectively refer to as U.S.-based banks, indirectly borrow in Eurodollars by accepting Eurodollar deposits through offshore branches and then transferring the funds onshore. U.S.-based banks take Eurodollar deposits predominantly through their Caribbean branches (usually located in the Bahamas and the Cayman Islands). While these trades are booked offshore, the transactions are typically negotiated by traders located in the United States and the proceeds are often used to fund U.S. operations.

In the United States, Eurodollars and fed funds are regulated similarly. Fed funds, according to Regulation D, are exempt from reserve requirements. Although the Fed can impose reserve requirements on net Eurodollar deposits of U.S.-based banks, it has imposed a zero reserve requirement since 1990, making the treatment of Eurodollars effectively the same as fed funds. As a result, U.S.-based banks consider funding through fed funds and Eurodollars to be close substitutes. An important difference, however, is that fed funds can only be lent by depository institutions, government-sponsored enterprises, and a few other eligible entities, whereas a broader set of institutions can invest in Eurodollar deposits.

The eurodollar and fed funds markets as currently functioning do not have many active lenders and investors that overlap. The decline in relevance of the Fed funds market is one of the reasons the Fed is seeking to supplant the fed effective rate with the overnight bank funding rate (OBFR).

The what?

It’s ok. Only short-term interest rate geeks have paid attention to it so far. Here are the details, excerpted from Overnight Bank Funding Rate Data by the Federal Reserve Bank of New York :

The overnight bank funding rate is calculated using federal funds transactions and certain Eurodollar transactions. The federal funds market consists of domestic unsecured borrowings in U.S. dollars by depository institutions from other depository institutions and certain other entities, primarily government-sponsored enterprises, while the Eurodollar market consists of unsecured U.S. dollar deposits held at banks or bank branches outside of the United States. U.S.-based banks can also take Eurodollar deposits domestically through international banking facilities (IBFs).

The overnight bank funding rate (OBFR) is calculated as a volume-weighted median of overnight federal funds transactions and Eurodollar transactions reported in the FR 2420 Report of Selected Money Market Rates.

The daily volume in fed funds transactions is roughly $65 billion. The daily volume in OBFR – which is fed funds + US-based eurodollar transactions – is roughly $250 billion. So the US-based eurodollar market with about $185 billion in average daily trading volume is much deeper and more liquid than the fed funds market.

Pressure in Commercial Paper Market Impacts USD Financing for Foreign Banks

To the extent that US-based banks experience any financing stress propagating to these two funding markets, the OBFR should detect it. Any deviation between OBFR and overnight Libor should be due to difference in the cost of eurodollar deposits for US-based and non-US based banks. Currently that difference is 1.8 bps (see graph below). As stated previously, that may sound trivial, but considering there has been no fundamental shift in credit quality, a pure regulatory change has produced a small financing gap between US-based banks and foreign banks requiring USD funds.

Why has the gap appeared? Because the biggest issuers in the financial CP market are foreign banks and other foreign financials. Wholly domestic issuers that are US-owned (the red line in graph below) are the minority of issuers in the financial CP market. 

Therefore any rise in rates in the financial CP disproportionately affects foreign-based firms, with or without domestic operations. That also accounts for the rise in Libor rates – particularly 3m Libor, which is closely tracking the rise in 90-day financial CP. That’s what we examine next: how the redefinition of Libor has created a much closer link between other wholesale funding markets, and no longer reflects a purely inter-bank lending rate.

The Redefinition of Libor

The Libor acronym comes from London Interbank Offered Rate. The old definition of Libor, under the previous administrator the British Bankers’ Association (BBA), asked panel banks to submit rates at which they believed they could borrow funds (e.g. be offered eurodollar deposits) from another bank for various terms, from overnight to one year. The panel banks were chosen to be AA-rated global banks with branches in London. Libor rates were therefore understood to reflect inter-bank lending rates for offshore funds in various currencies.

Prior to 2012, the rate submission process was: outside the regulatory perimeter, largely unsupervised, and conflicts of interest were not addressed. The explosion of the Libor scandal revealed persistent and at times widespread manipulation of the Libor rate submission process by traders, lax oversight by the BBA who repeatedly ignored warnings that the rates being submitted were tampered with and did not reflect actual borrowing rates, and pressure at times during the crisis from both bank management (and reportedly at least one government central banker) to report lower borrowing rates so that banks and the global financial system would appear more stable than perhaps they were. Legal ramifications from the Libor scandal have already landed several people in jail and resulted in a massive reform effort aimed at restoring confidence in the widely used interest rate benchmarks (e.g. Libor is referenced by an estimated US $350 trillion of outstanding contracts in maturities ranging from overnight to more than 30 years).  

A Broader, Transaction-Based Definition of LIBOR, Incorporating Commercial Paper

On March 18^th, 2016 the London-based Intercontinental Exchange (ICE), the benchmark administrator for Libor that replaced the BBA, published a revised Roadmap for ICE LIBOR which formally changed the definition and rules for the calculation of Libor rates across the five major currencies it oversees (USD, EUR, CHF, GBP and JPY).

The following are excerpts from the Roadmap explain some of the reasoning behind the change in the definition of Libor addressing: 

• The dramatic expansion of the counterparty list for tracking wholesale bank funding transactions; 
• The broadening of the funding locations included from a purely London-based market to a global market; 
• And, of course, anchoring the rates submitted in actual transactions as opposed to freeform estimates of funding costs, where these transactions include: unsecured deposits, commercial paper and certificates of deposit. 

Bingo. USD Libor is now directly linked not only to eurodollar deposits but also to the USD commercial paper and CD markets.

Note: that the Intercontinental Benchmark Administrator (IBA) is the group within ICE responsible for overseeing (edited for brevity and spelling, emphasis added):

Counterparty Types

LIBOR was initially created to be a gauge of unsecured funding for banks which was, to a very great extent, driven by interbank activity prior to the financial crisis.

The activity in that market has decreased markedly and wholesale deposits negotiated with other counterparties are playing an increasingly important role in bank funding. This change of behavior led IBA to conclude that unsecured loans by corporates (i.e. non-financial corporations, termed in the Feedback Statement and in this Roadmap as “corporations”) in addition to financial institutions should be eligible as counterparties to transactions that inform LIBOR submissions - where the bank is the borrower and the corporation is the lender.

The feedback to the consultation confirmed that, consistent with the original purpose of LIBOR and to reflect the changes in bank funding in recent years, a broader set of wholesale funding entities should be regarded as eligible counterparty types.

In calculating their LIBOR submissions, panel banks will use transactions where they receive funding from the following wholesale market counterparties:

 Banks

 Central Banks

 Corporations as counterparties to a bank’s funding transactions but only for maturities greater than 35 calendar days

 Government entities (including local /quasi-governmental organizations)

 Multilateral Development Banks

 Non-Bank Financial Institutions, including Money Market Managers and Insurers

 Sovereign Wealth Funds, and

 Supranational Corporations.

Including trades with corporations will increase the quantity of transaction data available to set the rate thus also helping LIBOR to meet the strategic direction set by the FSB and other official sector bodies for anchoring LIBOR in transactions. IBA estimates that the inclusion of such trades could increase the transaction volume by up to 15%, depending on the relevant currency and tenor.

Funding Locations

LIBOR is a global rate and transactions from an expanded list of funding centers will be used. IBA will maintain an Approved List of Funding Locations.

The Approved List of Funding Locations will be owned by the LIBOR Oversight Committee and will be based on the major centers in Canada, USA, EU, EFTA, Hong Kong, Singapore, Japan and Australia. This list can be adjusted as necessary according to a set of predefined criteria:

 a material level of transactions that will inform transaction-based calculations

 a satisfactory regulatory oversight regime for wholesale funding transactions

 an absence of capital controls, sanctions or other regulatory steps that would influence rates, and

 The location is used by one or more bank(s) or a bank has requested to use the location.

Since each of the LIBOR panel banks has its own organizational and geographical profile, IBA will agree the appropriate locations with each bank bilaterally from the Approved List of Funding Locations, being mindful of the need to safeguard the representativeness of the transactions and their pricing.

Product Types

IBA is standardizing the acceptable Level 1 (Transactions) as the VWAP of transactions in the following:

 Unsecured Deposits

 Commercial Paper – fixed-rate primary issuances only, and

 Certificates of Deposit - fixed-rate primary issuances only.

Closing Remarks

There is certainly a great benefit to expanding the definition of Libor to encompass the range of global wholesale bank funding markets and the variety of counterparties that lend in these markets. Clearly such a redefinition is supported by regulators and central banks, and will provide a clearer picture of bank funding costs over time.

The potential downside is that these various wholesale funding markets are not nearly as fungible as those regulators appear to assume. So a regulatory induced twitch in one source of funding is now be immediately propagated to Libor, driving up rates for consumers, non-financial corporations and effectively the entire financial market complex outside of what was once strictly AA-bank lending. That’s not necessarily unreasonable, but it does perhaps beget more caution on the part of the SEC, the Fed, the ECB and the myriad of other regulators before they go blithely handing down rule changes.