John Williams, the third in command of the Federal Reserve and President of the New York Fed, announced on Thursday that the Fed will establish an institution composed of private market participants to oversee the use of interest rate benchmarks or reference rates across the entire financial market. This institution will be named the Reference Rate Usage Committee (RRUC), and its first meeting will be held on October 9th.
Williams announced the decision at the opening ceremony of the 10th Annual Conference of the New York Federal Reserve on the US treasury bond Market held on the same day.
Williams said, "The Reference Rate Usage Committee will begin its meetings in October, focusing on key issues related to the reference rate, including how the use of the reference rate has evolved and what changes may occur in the market that supports the reference rate
The third in command of the Federal Reserve also added that the group convened by the New York Fed will "promote" "best practices" related to the use of reference rates, including recommendations from the Reserve backed Alternative Reference Rate Committee (ARRC).
The reference interest rate is used as a benchmark for setting other interest rates. With the withdrawal of LIBOR, the most important market reference interest rate in the past half century, from the historical stage, in the United States, the alternative option locked by the Alternative Reference Interest Rate Committee in recent years is the Secured Overnight Financing Rate (SOFR), which is derived from the overnight repurchase agreement with US treasury bond bonds as collateral.
The LIBOR manipulation case during the 2008 financial crisis and the scandal of multiple major banks colluding to modify LIBOR for profit in 2012 were exposed, causing LIBOR to face a "crisis of trust" and gradually losing market liquidity support. Since 2012, the scandal of manipulating LIBOR internationally has had a profound impact on financial institutions, prompting regulatory agencies in various countries to jointly promote interest rate reform.
Regarding this historical lesson, Williams said, "The LIBOR incident taught us two important lessons - first, massive systemic risks will gradually form in the global financial system over time; second, solving this problem will require complex, expensive, and decade long efforts. We must not repeat the same mistakes
It is worth mentioning that the New York Federal Reserve had just suggested modifying the calculation method of SOFR in July. Many Wall Street strategists also believe that potential modifications are necessary given the evolution of the repo market since the introduction of this benchmark in 2018.
At present, SOFR still has two obvious shortcomings: one is the lack of forward-looking interest rate curves, and the other is the lack of credit components, both of which are key features of Libor that SOFR lacks.
We actually introduced this aspect more than a year ago when LIBOR officially withdrew from the historical stage:
The term structure of SOFR is not as complete as LIBOR - LIBOR has seven terms, while SOFR is an overnight repo rate based on transactions in the US treasury bond bond repo market. Even CME's futures trading based on USD overnight SOFR currently only includes four terms: 1 month, 3 months, 6 months, and 12 months.
In addition, SOFR is the interest rate for treasury bond bond repo transactions, which does not contain credit risk and may not accurately reflect the real financing costs of financial institutions. Using SOFR as the benchmark for interest rates may also increase the difficulty of international comparisons.
Williams said, "The work of the Reference Rate Usage Committee will complement the efforts of the Bank for International Settlements and the Financial Stability Board in the use of interest rate benchmarks on an international scale, ensuring that we will not face issues similar to Libor again
According to the announcement, Patrick Howard, Deputy Chief Risk Officer of Morgan Stanley, will serve as the first chairman of the Reference Rate Usage Committee. He said in a press release, "The financial industry and the public sector must work closely together to support the sustainable use of reference rates