The Repo Market Dislocation: Part II
the Fed's major rates benchmark is growing volatile
— click here for The Repo Market Dislocation: Part I
The most significant monetary shift in recent history has ended. SOFR1, the Federal Reserve’s primary repo rate benchmark — which measures the average cost to borrow cash secured against U.S. Treasuries — is now employed by global finance to price trillions of dollars in financial assets. Despite intense skepticism, the move away from LIBOR2, a benchmark based on global banks’ supposed costs to borrow unsecured dollars3, has been accomplished. An estimated $74 trillion in LIBOR exposures4 will slowly mature, marking the end of an unsecured monetary standard. But now, as another prominent shift in market structure has emerged, LIBOR’s successor is also becoming defective. With officials already responding, the Fed’s latest dollar rate benchmark, SOFR, is about to transform.
In 2014, the Fed called upon numerous branches of government, plus various private and public sector giants, to architect a new dollar standard. The U.S. central bank and its newly established committee, the ARRC, vowed to replace LIBOR with one out of multiple proposed alternatives, including Treasury bill yields, swap rates, and even Fed Funds (EFFR). This list, however, fell swiftly to two leading candidates: a rate based on overnight repos backed by U.S. Treasuries (soon to be SOFR) and OBFR, the Overnight Bank Funding Rate. Published by the Fed since early 2016, OBFR aimed to measure banks’ funding costs in unsecured onshore markets, namely Fed Funds and dollars deposited at U.S. banks, as well as opaque offshore markets known as Eurodollars. The Fed’s proliferation of its swap lines after the Great Financial Crisis (GFC) had driven market participants to view onshore and offshore dollars as equals. Fed Funds and Eurodollars thus began trading as near substitutes, forming a global unsecured dollar standard.
Yet the GFC forever tainted monetary leaders’ and financial giants’ mindsets toward unsecured lending. As a result, trading volumes in the unsecured markets collapsed as Basel III and other regulations slowly became binding. As of 2015, volumes measured by the Fed via OBFR totaled just $250 billion. Soon after, via significant reforms, the SEC discouraged prime money funds (MMFs) from lending dollars unsecured in the Carribean-based Eurodollar market, the largest Eurodollar segment, reducing OBFR volumes to below $100 billion by late 2016. As OBFR measured a steady or decreasing5 amount of unsecured dollar dealings, it was destined to fail as a reliable benchmark. Meanwhile, activity in secured money markets was flourishing.
By 2017, repo market volumes, which the Fed could observe, had reached up to $1 trillion daily. With secured dollar funding markets possessing greater depth than OBFR, the Fed’s decision to implement a secured rate benchmark was assured. LIBOR’s longstanding reign as king of funding markets had ended. A dollar standard based on secured rates was emerging.