This Is What Happened To LIBOR During The COVID Crisis

about it. But I will say some of the episodes, um that were early in our series, we actually recorded those before we had the big March sell off in all the volatility that we saw in the market. So I think we should actually have another discussion about what we've seen this year with the coronavirus crisis and what it might mean for the library transition. Yeah, no, I agree. I do think like it's it's good to talk big picture and the sort of long term trajectory of what's

coming for Library and the replacement. But in the meantime, Library still exist, and so talking about how this benchmark, uh, you know, what's happened with it during the extraordinary several weeks and months for the market is a sort of

a useful thing as well. I hope, yeah. And I guess the big tension that sort of emerges is should we be attempting to do this big redesign of the financial system, basically redesigning the reference rate to which trillions of dollars of assets are tied at a time when we're distracted by so much else going on in finance. Right We're in the middle of a financial or maybe not financial but an economic crisis. The Federal Reserve is rolling out all these new programs. Regulators are you know,

looking at financial stability things like that. Should we be tackling library at this exact moment? So we're going to explore that tension in this discussion. And we have a guest today who is a fan favorite for sure. People we've had him on before and he had been requested a lot, and then even again I've got requests like, oh, you should talk to him again. So everything is aligning

for this episode are the culmination of the series. The interest rate stars have aligned for us, all right, Well, without further ado, let's bring on Josh Younger ahead of us. Interest rate derivative strategy over at JP Morgan And as you mentioned, Joe, a previous odd lots of guests who talked a lot about some of the turmoil that we saw in the treasury market in March. Josh, it's great to have you back on Yeah, it's great to be back.

Thanks for having me. So maybe just to begin with, you could give us a sort of summary of what happened to libor in March when we had the market volatility, and not just market volatility, but we did start to see the beginnings of some concerns about the banking system and that sort of reflected in the interbank lending rates.

So what did we see So, so I think it's it's best to go back to two thousand eight, and and that was an environment where live Or was this really important kind of canary in the coal mine for bank funding stress and ultimately the stability of financial institutions.

So when library started to move and other short term rates like FED policy expectations did not, and that spread, that difference widened out, it ended up being a really important forward looking indicator for the for the problems that we're gonna come and ultimately led to bailouts and a couple of near or actual bankruptcies, and and all of the problems that the financial system was facing we're kind

of pre presaged by moves in liborary. So that's been something people have watched for a while, and there have been episode is over the past twelve years where library was once again in the spotlight. And the best example of that was the European sovereign funding stress episodes of and twelve UM, when initially Greece and ultimately Italy in

Spain we're coming under stress. Their banks were either directly or or or implicitly part of the libar panel um and we can talk about that as well, but the banks in Europe were all interconnected to some extent, and problems in Italy and Italian banks were ultimately problems for German and French banks, and that went into the librar fixing and library oh I s so I s being

fed funds, you know, fed policy expectations. The difference between these two rates widened out quite a bit, so that was ultimately like something people watched, is this financial stability financial conditions indicator. Uh. More recently, we we saw an even larger widening in the in library versus O I S back in March, and so that was really the

largest movement that spread since two thousand eight. And it was immediately questions as to whether this was another canary in the cold mine, meaning, you know, libras is widening up.

Does that mean as much as the banks are telling us that everything's fine and we're better capitalized and we're more stable and we have all this high quality liquid asset stock to rely upon to raise liquidity, like are we actually in trouble and the market knows about it, but maybe the public doesn't get and and that's priced

into the library. So, um, this was one of the two or three things that was really closely watched by a variety of people and ultimately, you know, the public because you problems with banks or problems for the economy, especially in a major economic shock at the same time.

Um So, so then all the questions really surrounded what was actually driving this move and librar was Librard telling us something about the banking system or was Livebrard telling us something about the way that we construct live RRE. Now that's much more technical and frankly less interesting to the broader public. Um. And it turned out to be

mostly glad to explain that further. I mean, actually, when we talked to you last time, which we've actually been at the very end of March or maybe early April, we still were right in the thick of the volatility. But a lot of that conversation was about what was going on, not with the banks per se, but with other entities that were trading treasuries and trading futures and the illiquidity in that space. So from your perspective, what what was librar, What was that widening really telling us?

And what did it have to do with the volatility at the time. Yeah, so's ultimately the question is what are we really seeing when we see a live RAR fixing. Let's say today library is thirty five basis points? Like, what what is that number? What goes into that number? In the pre crisis days where there was a lot of interbank trading, of of short term lending and so forth, like library had actual transactions behind it because banks would

do those short term loans relative to each other. Um. But you know, somewhat tongue in cheep, we say, these days there's no eye and library. The eye stands for inter bank and there's no interbank trading. Where there's no significant interbank trading, and so the Intercontinental Exchange is that is the benchmark administrator. They put out a couple of years ago revised guidance for panelists as to how this

submit their quotes, so to quickly review your library. Is this panel of banks, large international banks that are active in short term markets. Every day they're asked where they think they can borrow, and they're supposed to put in a number, And you don't have the option to just pass, so you have to put a number in every day. Um. It's easy to put in a number if you spending

borrowed money that day. Um. And that was very frequently the case in in the sort of two thousand and two thousand eight period um, and even earlier than that. The problem is now, because there's not much inter bank lending and borrowing, they're forced to rely on the commercial paper market. So the question is did I issue commercial paper or a certificate of deposit today? Um? And if I did, then I've got a really great way to make my quote because I borrowed money today, let's say

borrowed at forty basis points. So I tell the ice that I borrowed at forty basis points. But when we look back over the past year or so, on average of the sixteen panelists, only say four or five on average are doing that on a given day. So what do I do if I don't have a transaction to

point to? And the the ICE released what they called the Waterfall, basically a prioritized list of other things you can look at, uh to come up with a number that's supposed to be like close to where you could borrow, but you're inferring it, you're not actually observing it. So one of the interesting things that happened to lieb Or in March was it it hit a pretty sharp peak.

I think it was something like I want to say, one point four or one point five, and then it took quite a long time to sort of start coming down, even though the Federal Reserve was unveiling all these new programs to inject liquidity into the economy. The technical dynamics that you're describing, is that something that would um, I guess, prevent a central bank stimulus measures or monetary easing from impacting the library as well. Yeah, there's definitely a policy

transmission issues. So when the Fed moves interest rates around, they're ultimately trying to stimulate the economy through the cost of loans. The problem is they target the federal funds rate, and there's not a ton of loans tied to the federal funds rate. So when the Fed moves interest rates, they rely on the relationship between that that federal funds rates and other interest rates to to actually sort of

get the stimulus into the real economy. And I'm sure your other guests spoke about the live war is by far the most pervasive of those interest rates, so to some extent, if it doesn't get passed through the library, then it doesn't have nearly the same effect. And when the Fed cut rates a hundred basis points, library didn't really move in March, and so you didn't really have a ton of stimulus, at least immediately into the economy.

There's also the question of whether interest rates were really the thing that was causing issues, which I think is a different conversation for somebody with more economics training than me. But but if we say the Feds trying to do what they can, lowering interest rates is the is the most straightforward and classic thing they can do. If that's not passed through the live or because of these technical issues,

you've got a problem. And so you know, it was kind of alluding to earlier is that there weren't a lot of transactions. And when we talked in April, one of the issues was that the capital markets essentially shut down. So what was typically four or five panelists issuing commercial paper on a given day, which is again pretty small for action of total number of panelists. Uh, that number went to like two or three when when library was rising.

So the rise in library to a large extent reflected other kinds of funding stress that are not really tied to like bank credit. So this wasn't really about the ability of banks to repay loans because of the risk of bankruptcy or failure. It was about the cost of securing dollars through other sources and just the scarcity of dollar funding in general, which is a very different thing

and frankly much less concerning for overall financial stability. Because the bank credit is in question that has all kinds of knock on consequences for the economy, which we learned about in two thousand two nine. Well, so, okay, so in March, the rise in the library didn't necessarily reflect what was going on with bank credit, which is good.

But in terms of its function as a benchmark for all kinds of loans and derivatives and other instruments, was it still basically serving its purpose if it was a measure of overall funding conditions or funding stress elsewhere in the financial system, that doesn't necessarily strike me as a bad measure to still use if we're going for live Or's main purpose. Well, so I guess when we think about live or, like what is it supposed to do?

Like why do we make an index out of bank borrowing in the first place, Because we could have just tied everything to FED funds or or the prime rate, like we have the prime rate. That's an alternative um. And when we initially constructed live Or, the idea was, you know, I need some kind of credit components. So using Fed funds of the prime rate is not a great measure because like this is a benchmark against which

loans to individuals and corporations it's getting measured. So I want some elements of underlying credit risk in this index. So who's the best credit around? Arguably it's it's the

largest international banks. So the question is, if I want to borrow any I Josh, want to take out an adjustable rate mortgage, my credit is bases points worse than a good bank, right, And so I have this like benchmark that's tied to ultimately private market, you know, credit exposed institution, but one that's kind of high up on

the on the scale of qualities of credit. Um so when you have live or moving because of broader funding market conditions, and that really means the ability to find those lendable dollars the very technical thing, right, I mean, if you're unconcerned about getting your money back, but you just don't have the dollars to lend because they're locked up somewhere else, so you can't pass them through the

pipes effectively. Like, is that really the benchmark we want to use for adjustable rate mortgages, for corporate debt, for corporate loans, for for the main street lending facility. And so the question is is not whether or not these disruptions happened, because you know, any imperfect measure is going to have issues occasionally. The question is is this something I can expect to persist over long periods of time?

Is it going to lead to a lot of volatility in interest rates that's not really reflective of the credit markets, And so am I sort of creating more trouble than it's it's worth and in tying the lending market or continuing to tie it to this bank credit index that's constructed in this in perfect way. So I think you

actually coined the term zombie liabor. I think you were writing about that possibility back in September when you look at what was happening in March, where you know, you didn't have a lot of these lending transactions on which to actually base libror. Do you think the risk of ending up with zombie library, as you put it, is increased or that there's proof that we're sort of heading

in that direction. Well, the zombie library outcome, and just to review that, that's a scenario in which you have this panel of sixteen banks, and starting in the beginning of two the regulators are going to allow banks to drop off the panel. They're no longer going to compel membership because at the moment, if you want to get off the library panel, it's actually not so easy to do. And they're doing that because they need a decent number of banks to get a decent sample in that in

that index. And so when people talk about librars quote unquote going away at the end of two, what they're referencing is is the f c A, the Financial Conduct Authorities statement that they will no longer compel membership. And so the presumption is if you don't have to stay in that club to which you would not like to

join or remain, you'll leave UM. And and there's lots of reasons why why one would want to leave that that particular panel, and so zombie Library is a scenario where a lot of banks leave, but not everybody does, and your left with a kind of small contingent of say five or six submitters, and that leads to a lot of volatility, because if you pick the wrong set of five, you could end up with a much more volatile index. What thankfully, there's kind of a regulatory solution

to this. So UM if the f c A and and the benchmark Administrator coordinate to some extent um, they can come up with a scenario where the f c A deems Library nonrepresentative, and instead of continuing to post fixings because the ice the benchmark administrator, they're under no obligation to keep posting Library or to stop posting Library, but the SEA can simply say they don't think it's representative,

but you can keep producing fixings. Um. They have come together and said, look, we're not going to do that. If if the f c A says Library has entered a stage where it just is no longer representative of credit markets, then we the benchmark administrator, will stop publishing it pretty soon thereafter. So I'm sort of less concerned

about that at the moment because of that coordination. UM. And that's a good thing because like all of the rules and will probably talk about fallbacks and all these other things, like if Library is still getting produced, unless you specifically account for that scenario, you could end up in a situation where you keep having a reference a rate that is increasingly problematic. And Library has its problems now, but there's sixteen contributors, imagine there were five or six,

and and all the problems would be magnified. So just while we're talking about the events of the last couple of months, I mean, one of the things is this series has gone on. We've talked about the various steps, the difficulty and transition. Of course, we wanted to get your broader perspective on that. But have there been any substantive ways in which what we've seen since the beginning of this crisis has changed the planning and overall trajectory.

So it hasn't changed the planning. The question is how we I think it comes back to the of like, how are you actually going to do this thing? Meaning we can say we want to get off of live or we can threaten to get rid of lib or, But unless all the pieces are in place, that's a pretty risky proposition because you're now talking about ripping out one of the central elements of the financial system UM

in a pretty rapid fashion. Io is not that far away, and so you've really got to make sure that you've kind of ring fence the potential risks around doing that, because I think we can all agree like, under normal circumstances, you don't want to destabilize the vast majority of the lending and derivatives markets, and you definitely don't want to

do that now. So what about March has made that either more or less likely getting those pieces in place to actually get to the to the point where we can we can say we're off of live RAR and specifically stop publishing it, because if you're to do that now, you'd have a lot of problems. Um. So the first thing you gotta do is you've got to come up with fallback language, which that takes care of the fact that when most of the existing loans and derivatives were written,

they didn't really contemplate a permanent end to live or. So. My my favorite example of this is in some some notes that are floating interest rate which is supposed to observe library every quarter. Um. They say, well, if there's no live or today, look at the last valid live orre fixing you can find and use that to calculate the payment, which makes total sense if you think it's

a day or two, but not if it's going away forever. So. Um, if you own a security that's supposed to pay you whatever library is now and library goes away, you're taking the risk that, like library goes away at a very low interest rate level, you just don't know, like we don't know what librar is going to be in the future, and so that's rolling the dice in a way that's not particularly appealing. Um. And if you go to the drivaters market, which one of your other guests might have

mentioned scales and stuff like that. But two trillion dollars is a lot of money, um, and those payments have been start to live bar. And the way those fallbacks were initially set up was they said, well, if live Board is not there today, then pick up the phone and call people and try to get them to quote

you a level on a more informal basis. And I think it's fair to say that if banks don't want to be in the Liveboard panel for variety of reasons including you know, liability and so forth, um, they definitely don't want to be picking up the phone and just

quoting something in an informal way. So um, in the case where you can't actually source informal quotes, then you're kind of at a dead end, which means there is no number with which to calculate the coupon payments on two trillion dollars of notional worth of derivative contracts, which, um, you know, if you were a lawyer, that would be a great set up, but for the rest of us, like,

that's not a great um situation to be in. And so like, the key is to amend all of these contracts, not just derivatives and loans, but also mortgages and the variety of other things to make sure they have, you know, clauses that take care of this eventuality. And and so that's the is to fall back protocol process. It sort of serves two purposes, is that being the Derivatives UM Industry Organization is putting forward standard language for all derivative

contracts take care of this. And what they're doing is they're using a historical observation of live orar versus SOFA, the secured overnight financing rate the replacement for lib orary. So look at the difference between those two things, look at its historical average, and now what you thought was gonna be library is now you know, sofur plus this spread that we're going to observe over the past five years, let's say, UM. So that's great for the derivatives market.

And they're they're close to putting out the triggering terms like under what circumstances do you do this specifically, how do you actually calculate this spread, etcetera. And and they're close to being done with that. And the key there is that once you have a standard UM language, you

can incorporate it into other things. So a lot of the push has been to make sure that all of the cash products, all the securities and loans and and and other non derivative instruments basically align with whatever language is that comes up with because then you have a single industry standard. That's a good thing. UM. Just less to argue about. UM. The only thing is that the hedges that are used to manage risk associated with those investments are going to have the same fallbacks because the

last thing you want. You think about a large financial institution, UM, like a major commercial bank, they have you know, hundreds of billions of dollars potentially in interest rate swaps, and those are used to fund or at least their associated with the funding of assets. And so you know, if you've even a small mismatch in the way those fallbacks are triggered, that could be a very destabilizing thing as well.

So you want everything everything lined up nice and nice and uniform and matched off across the whole range of things with live or exposure. So so that's the first thing, that's the first step. Shot. Let you well, it does feel like the industry is basically attempting this gargantuan feat at a very very tricky time, and we have these

key deadlines coming up as well. Do you get the sense that anyone is sort of reconsidering the transition in the current environment or are are they still pushing forward um to the extent that they were earlier. So there's there's still a lot of pressure to get it done UM. The the UK Regulator has said plan on two UM. They've acknowledged the risks, but the guidance has been to plan on the original schedule. UM. The fall back stuff I was talking about, that's mostly done, so I wouldn't

necessarily do that as a big concern. The issue is how are we going to jump start a new market in the middle of a market crisis? And so the sofer market is is new like, there's not that much of it out there. There's been a decent amount of issuance of securities that referenced sofur, but they're almost all

from three government sponsored issuers. There's some trading in derivatives both on the exchange the futures contracts and then, but much less in the over the counter swap market, and so like, you don't have a lot of transparency and visibility into uh, that component that's going to become central to everything. Like, we don't have a great sense of of how the market would manage risk around around sofur

catch flows. And the question, and this is the part that I think is is the risk factor that you're you're alluding to, Um, how do we get people to trade sof Mike, how do we actually push people in that direction? Because um, you know this book Nudge, which says you put in small incentives, people will tend on masks to go in one way. Financial markets don't have nudges.

They have shops like we don't we don't do small things Crementally, there really needs to be a strong push because familiarity and liquidity and and and and you know overall risk management strategies that tied to things, it's just hard to move. And so we need some kind of lever arm to push the market from live world to sofa. And this is where there's a there's an interesting way in which we can utilize the post two eight crisis.

I guess with the specify the crisis now, but the post two thousand and eight crisis regulatory regime said we're worried about interest rate swaps between two counterparties. So we want you to all use a centralized counterparty. This is this is CME and LC huh, this is the clearing houses. And so the idea was have a central counterparty to

which all swaps are eventually facing. And that means that you can make sure that that entity is well capitalized and kind of transparency and and so and just a much less complicated market. And the reason I'm highlighting this is that at central counterparty now has an enormous amount of influence over how the swaps market trades, because basically everybody with very few exceptions are relatively few exceptions, has

to do business with the centralized counterparties. There's two of them, to see ME and LC h so UM, the Alternative Reference Rate Committee and others have been coordinating with them. And it turns out there is an asset which is quite large, very actively hedged and um and and controlled in some sense by the decisions that these two central counterparties make. And that is the value of all U S dollar interest rate derivatives. So if I have a swap contract that I executed a year ago, it was

word zero at the beginning. This is true of all derivatives, right, they have zero value at initiation. But now let's say it's worth five million dollars. So how did I come up with that number? What you do is you say, what's the what's what are the terms of this count tracked? How did they compare to the current terms of the contract, And what is my discount factor? What is the time value of money that I should assume in calculate the present value of those cash flests? And this also sounds

relatively technical. The key is that the clearing houses use a particular interest rate to calculate the value of those swap contracts. The gross value of those swap contracts is something like one and a half trillion dollars at times um, and it is very heavily influenced by the choice of that interest rate, and they can in principle change that interest rate from the effective Federal funds rate, which is what it is now two so fur so. So now

I've created an asset that is very highly correlated. It's values very highly correlated to the SOFA rate. It's very large, it's trillion dollars um, and its value changes a lot because its interest rates move, the value of interest rate swaps changes, and that means that if I was hedging changes in these valuations, I need to change my hedges.

And banks do that a lot. So I sort of created a very highly call it convex, meaning it's value changes as interest rates move, very highly convex, pretty large, very explicitly tied to sofa asset. And now the banks are all going to have to hedge. They're going to do that with sofa swaps, and so all of a sudden, I've created an environment where there is a lot of trading and activity in sofa linked UM instruments, and I've

jumped started the market. And the plan was to do this in October UM and and the clearing houses had agreed to this, they came up with a plan for it um. The problem is that plan relies in part on the willingness of the market to kind of price out, to put together expectations for what long term sofa payments would look like versus other interest rates. And the experience of the past two months has not been great for

that kind of activity. So the risk is that in affecting this transition, and in affecting the transition of the valuation of interest rate derivatives, you sort of cause significant problems because there's not enough buy in from the counterpart you need, and that would be very disruptive if we were to happen. Can you just explain that last part again?

Uh spelled out what the risks would be. And is there a possibility that that date in October could just, I don't know, move to early next year or something like that. Yeah. So, like if I'm a centralized counterparty

and I'm going to switch my discount factor. So let's say I've got a hundred trades and they're currently worth ten million dollars using the discount factor I currently use, and I'm going to change to that from the effect of federal fundrates to sofa Well, I need to know what that not just what the sofa rate is, but what the expectation for the difference between the new discount factor and the old discount factor are going out ten, twenty,

even thirty years. And so the way these expectations are usually arrived at as you have a population of specialists who really do these kinds of trades. So there's a whole market in like thirty year average difference between the federal funds rate and live work like we trade swaps like that, and there's a population of investors who come up with those expectations or a variety of means and then gets priced into the market and there's an observable

benchmark UM. So if they participate in these in these discounting factors switches, then we can actually do it UM. If they don't, then you're left with a new discount factor that nobody knows well and the valuation of the whole swaps market becomes highly uncertain. It's not a great outcome UM, and you've sort of created more problems than

you solved UM. And there's a risk that there are significant losses that percolate through the system and those who are most exposed to UM the small differences in in valuation are going to be you know, participants in the market who have lots and lots and lots and lots and lots of positions that are mostly netted off but has small residual differences. That's a dealer, like that's a

bank because their market making and all these things. UM. So uncertainty is bad for this whole process, and if you try to push it overligned quick and you don't get the buy in from the specific participants that you need, you end up creating a lot of uncertainty. Um. At the moment, it's it's sort of full steam ahead, and you know, the thought is October is a long way away. Things look a lot better, markets mostly stabilized at this point. Um.

You know, I've seen no reason to delay it. UM. I think as we get closer to the data will become clear if there is sufficient buy in from the right people. UM. But you know at the moment that the thought is I would stand schedule because if we don't do this, then we can't do the other things. And you know, when once you have people trading swaps. Then let's say you were a corporate borrower in Middle America and you've got a loan that is currently live

or plus in your bank. Collegy and says, you know, we just changed this new interest rate called SOFA, and you know we need to quote you a new spread, so we're gonna make it SOFA plus three and a half percent. And your immediate response would be, I don't know what SOFA is, So explain that to me and to how did you come up with three and a half percent and the and the best way to do that is to have some derivative traded that you can point to and say, look, the market is pricing this

set of expectations. So for your five year loan, the market says the difference between live or and sofa is going to be half a percent, So it's fair for me to charge you an extra half a percent because that sofa it is going to be lower on average over the next five UM. To do that you need to have trading and sofa swaps, and and to have

that you need the big bank. So it's all about laying up the pieces over the next six to twelve months so that ultimately we can have a loan market that's mostly at least new loans are mostly benchmark to sofur um and you have that pricing transparency. Um, You've got you know, participants and users of interest rate derivatives moving them to the new index. You can have the mortgage market moving to the new index. For the most part.

You know, you're you're starting to whittle down the population of Livebrard products that you have because at the moment it's it's still growing like the the the market's overall risk to live AR has increased, not decreased over the past year, even as the deadline has approached. And it's because people are used to Library when we write new

loans now we typically do and versus Live wrary. Still, most of those credit facilities that have been drawn on in the crisis, most of them are linked to Library UM. Most of the like the FED program, was originally gonna be linked to Sofa, but they changed to the library because the market is not ready for sofa lenked main

street lending loans. So you know the way we and if you if you have this thing where the risk you're trying to manage down keeps going up, it's not a good setup to get rid of Library two years.

So so unless you put these pieces together in a relatively precisely sequenced fashion and quickly, you're not going to have a situation where the market's ready to get off of live or you know, on schedule with respect to the deadlines the phone, Josh, you mentioned these specialists who are very good and practiced at pricing these things out

for a long time. When it comes to the just real quickly, when it comes to the switch to sofa is learning more technical challenge from their perspective, or is it again just sort of habit and inertia in terms of whether they'll be uh, you know, fully ready to do that in buying into it. I think it's a

couple of things. The first is it's technical in the sense that you know, we need to have a sort of theory of SOFUR and and how it relates to other interest rates and and we have a decent sense of it over the past US five to ten years.

But the world's changing pretty quickly. And so when the Treasury wants to issue five trillion dollars worth of collateral, it has implications for the repo market, which means it is implications for SOFER and so you know, what is the long term deficit outlook look like has a lot to say about how the repo market is going to behave You've got bank regulations that are changing, even on temporary basis. So it's hard. Um, that doesn't mean you

can't come up with a number. The key is if you might be wrong, you have to be in a position to to wear those losses and not have a problem. And the issue is that the one of the hardest hit communities, at least in the sort of institutional investor class. UM in March was the relative value hedge fund and asset manager community. And that's precisely you're relying on to

come up with these numbers. And so there's a lot less margin for error if you've had a bad year already, and the willingness to participate in saying it's voluntary, like you don't have to do this, UM if you're a hedge fund like you and just choose not to participate in so for and that's fine. UM. And so without that, by and it, it's just gonna be hard to keep the process moving along. It doesn't mean you can't sort of accept the risk of volatility and push forward and say, look,

you know, things look fine. I think they'll participate, and you know, even if they don't, you know, the miss will be small, and we'll just keep things on schedule because it's more important to stay on schedule. UM, given the level of risk that we perceive. That's a perfectly valid perspective, but you know, it's it's not clear to me that will obviously be the case come October. I wanted to ask you something sort of more conceptual about SOFA.

So you mentioned at the beginning of our conversation when you were talking about liebrar, the lieboard does have this credit component in the sense that it's basically a sort of interbank lending rate, and so for somewhat controversially doesn't have that credit component. How do you see that impacting the financial system and transact And does that mean that so far is inherently not a sort of perfect match for live ward. It's definitely not a perfect match. Um.

I think there's no good answer to this problem. So Um. On the one hand, library has credit exposure, which sort of is perceived to be beneficial in certain ways, but you know, it kind of depends on who you are in that equation. You know, the live world tends to go up when the market when interest rates go down. Um, that's just you know, interest rates go down when the economy is worse, and that means credit, the credit outlook is worse, and so liverar should go up for aative

to other interest rates. Uh. That works well if you're the lender, but not the borrower. So it sort of depends on your perspective. The other component of that is it's sort of perceived to be a good match to the other kinds of ways in which banks borrow um and and you know, that's another thing that that's arguably debatable, but it's been it's been put forward. The problem with library is that credit markets tend not to be very active crisis, which is precisely when you need the index

to be its most robust. And so that's what we were looking at in March, which is at precisely the time when FED policy needed to be passed through to the real economy through live war um. The rate of transactions was dropping significantly, like markets were seizing up um. The only market that was much more active, or one of the markets that was much more active, was the

repo market. So you know, the transactions that could in principle go into live ar in March were much fewer, and the transactions which went into sofare much greater, like the repo market got more active. So the advantage of this non credit link, the secure lending market so to speak, that that SOFA represents is that it is more active in a crisis, more robust in the crisis um than than in normal times. Well, this raises question to me, and I think we talked about in one of the

earlier episodes. Why couldn't the new benchmark just have been something a direct policy, right? I mean, if you're getting rid of the credit opponent, why not do you know, one month or three month or overnight rates from the Fed if that's essentially what it's going to track. So the federal funds rate is actually not a direct policy, right. So the federal funds rate is market determined by the

market um. In the pre crisis days, when the balance sheet was small, basically the FED would be the buyer and seller of reserves because federal funds rate is the cost of borrowing reserves on an overnight basis, so on borrowing cash from another bank um and specifically borrowing like reserves at the FED and in the pre crisis days, like the FED would sort of be the end borrower and lender to maintain a rate that was like pretty

consistent with their target um. As the balance she grew in the wake of the crisis and too, that's Nate.

They bought a ton of treasuries, a ton of mortgages agency the ventures, so the baluncy got a lot bigger, which meant there was a ton of cash in the market, and that meant that nobody really needed to borrow cash, be cause you would typically borrow cash to make sure that you were at your minimum reserve levels for regulatory purposes, like I need to hold Institution A needs fifty billion dollars worth the reserves, institution being needs sixty billion dollars

worth the reserves. Reserves don't earn interest in that pre crisis environment, and so I want to hold as little as possible and stay as close to my minimums as possible. Now, the FED has done two things. They've increased the supply enormously, and they pay interest. So if you're a bank and you have cash at the FED, you get into positive interest right on that cash. So you actually are perfectly find holding reserves for the most part at the FED.

You don't want to minimize your exposure. Um And the correlate to that is who would actually lends reserves when they're earning interest on them at a rate that that might be below the interest they earned by holding them overnight. And it turns out that the way that the regulations were changed, the way the law was changed to allow the FED to pay interest on reserves did not include

non depository institutions, So who's an depository institution. The federal Homeland banking system is technically not a depository institution, and so that meant is that they don't earn interest on their reserves, but they are part of the federal reserve system, so they lend out their cash at a rate below the interest on access reserves, and the borrowers of that cash are sort of borrowing below the interest on access reserves rate and earning the spread between the two, or

possibly doing it for other for more technical reasons, And so it turns out that the federal reserve policy rate, or the target policy rate, the effective federal funds rate, represents at best, on a typical day, billion dollars worth of transactions, which is better than live or um I should add, but but not a lot in the context the whole system, whereas SOFA represents more than a trillion

dollars in underlying transactions, many many thousands. And most importantly, the effective federal funds rate is a pretty idiosyncraticing because it really reflects where the homeland banking system is willing to lend out cash relative to other short term investments to foreign banks, which doesn't strike me as the index.

You really want to link the rest of the economy too, because it's a pretty technical, pretty idrisyncratic thing, and so SOFA represents a true market in the sense that there's many, many transactions, there are lots of borrowers and lenders, and it's it's a real price discovery process that's not sort of highly highly sensitive to to the minutia of things

like you know, homeland bank liquidity management. So so it's a much more attractive right and the are sort of considered both UM when they the Alternate Reference Rate Committee. They considered both UM and came to the conclusion that that this REPO rate, for all its problems, was a

much more desirable benchmark than things like fed funds. So, putting it all together and considering what we just experienced in March and April with live ar UM and sober to some extent, are you optimistic that we're going to meet the deadlines for the library transition? And I guess secondly, are you optimistic that that transition is going to be done in a way that's good for the financial system and that the ultimate outcome is going to be that the industry is in a better place than it was

in the library. Is yes, sorry, optimism is an interesting way to characterize it. I am. I'm convinced we'll get there. It is going to be the beginning of two first quarter, second quarter, second half. I think there's a real risk that it gets pushed back, just because when it comes down to it, the way you get the market off of lib or is you stop publishing lib rar and hope that you've covered all your bases, and there's always gonna be a moment where you bite your lip and

go I think it'll be fine. We did a ton of work. We we really looked in everything, but like, you never really know until you do it. So what what do I think I might have wrong? And and and ultimately, if if there's any concern about financial stability, you know this deadline. It's good to have a deadline. It's good to work towards a deadline. Um this deadline was not chosen for any reason other than we need

a deadline that's realistic. So if financial stability is truly at risk, I think turning off the lights and walking out of the live or room wherever it is, like, it's probably not a great idea. Whether or not that point will come with the point of confidence that you know we can take this risk comes you know, on time quote unquote is in the first part of two or or six or twelve months later. It is very

hard to say in advance. UM. I think it really depends on how the next three or six months ago, and especially that that discounting switch people called the big bank discounting switch. That's kind of the next big event um in that market. But you know, I'm optimistic that it will happen. I'm optimistic that, um, it will happen over a timeline that's not super long, and when we're not talking about twenty years at the end of the day.

If it if it ends up happening in the second half of two or the first half of three, like, it's that a complete disaster for the market. No, we've been working on this longer than we were working on the Moon landing, So what's an extra six months? So um, you know, I think that's it gives us a little flexibility,

which is not a bad thing. Um. In some sense, there's value to acting as if the deadline is is fixed because if it gets pushed back, but you're ready at the end of twenty one, you've got no problems. If you're not ready, then you then you've got a big problem. So, um, you know, I think the market will keep pushing towards these deadlines. Is it better for

the financialist system overall? You know, I think a more robust benchmark is always a better thing, and in particular one that's tied to transactions, because ultimately markets are about confidence and transparency. And so when we think about benchmarks that are embedded in basically everything the market touches, um that it really have wound into the into the guts and and the sort of ether of the financial system. Um, it's really important that they'd be something that we can

count on for a long time. UM. And and something like so far has a lot of features that are attractive, and the most important being that it has many transactions, very hard to manipulate. I'm sure when your prior guests talked about the manipulation scandal, it's really hard to manipulate something with that underlying transactions. It's a lot easier to do it when there are sixteen panels um. And it's a market with many participants, not just banks, So it's

a it's a broad mix. You know, secure lending is only getting more important because there's plenty of treasuries around and I don't think that's going to change anytime soon either. Um. So, uh, you know, all of that's a good thing. Um, as long as the process and the arc is put forward a very clear and and very reasonable and very thoughtful

and and and careful and to push this forward. I think at the end of the day, it's kind of like every new piece of significant legislation, like everyone leaves equally unhappy, and so librate transition will leave many people equally unhappy. Um. But but you know, financial stability and and and and confidence is key, and I think they're heading in that direction. Josh, that was a really great conversation as always, and it was lovely too happy back on.

And I'm so glad that you were the last person to sort of crown our overarching Live Boars series. So thanks thanks for being last, but definitely not least. Yeah, totally, I'm glad it worked out and trying to keep it not too technical. I hope that worked. I think it was just perfect, right right on the edge of sophistication. But I actually I think I understand I understood them with all of it, So I thought that was thanks. Okay, So I think we're done. I'm sort of scared to

say that. I think we are done with the librars here. Yeah, Josh, I think we're done for now. I mean, I do think you know, it's not the topic isn't going away. But that was a really good summary, Josh, and just so clear, and his ability to take a really sophisticated topic very detailed. I mean, when I try to read um on this topic, it's always difficult. But I think he's one of the sort of clearest articulators. So good way,

good way, good good place to stop. Yeah, he definitely has a way of bringing all these sort of various threads in the financial system together in a coherent way. So I guess I don't know about you, but the overarching takeaway is how difficult it is to sort of retool the underpinnings of the financial system, and especially to

try to do that at a moment like this. And of course, when everyone embarked on the why or transition, it was right after the two thousand eight crisis, and I'm sure most people were hoping that we weren't going to get another crisis for some time, and yet you know, here we are and we're basically trying to end the process in the midst of the biggest economic recession that

we've seen for many years. Yeah. Absolutely. It was just yesterday's episode, so speak we were talking about that, that moment with the clearinghouses coming up in October, and it's like, Okay, this is when they're going to switch over to this

new benchmark. But hearing Josh talk about why even that is going to be a challenge and how you need to get the buy in of people who are experts at pricing this stuff, that really is sort of illuminating about illuminating example of how just even one step it's

extremely complicated, and of course there are numerous other steps involved. Yeah, and I love that anecdote from Josh as well, about you know, language in the contracts that talks about, well, if there is no available library rate, you just go back to the previous one. And most people were expecting that to be you know, a day or two previously, but if you actually sunset libar, then you could be going back years and years and years. And it's all

stuff that people never really considered. They would have to do. Yeah, no, it was really great and maybe we should do another librar series, but like a year, you know, or six months or something, and then we'll see how it goes. We need to title this the Never Ending Library Series. That should be the name. I like it. Okay, all right, well, this has been another episode of the A Thoughts Podcast. I'm Tracy Alloway. You can follow me on Twitter at

Tracy Alloway and I'm Joe wi Isn'tal. You can follow me on Twitter at the Stalwart. Definitely be sure to follow our producer Laura Carlson, who had to book and edit all of these podcasts, all of the series to get him out in a single week. She's at Laura M. Carlson. Follow the Bloomberg head of podcast on Twitter, Francesca Leavi at Francesca Today, as well as all of our podcast at Bloomberg under the handle at podcasts. Thanks for listening.