Towards better reference rate practices: a central bank perspective

Executive summary

This Report reviews issues in relation to the use and production of reference interest rates from the perspective of central banks. These issues reflect the possible risks for monetary policy transmission and financial stability that may arise from deficiencies in the design of reference interest rates, market abuse, or from market participants using reference interest rates which embody economic exposures other than the ones they actually want or need. In parallel to initiatives in other forums and jurisdictions, including work by the International Organization of Securities Commissions (IOSCO), the European Banking Authority (EBA) / European Securities and Markets Authority (ESMA) and the UK Wheatley Review, the Report provides recommendations on how to improve reference rate practices from a central bank perspective. The Working Group (WG) identifies an urgent need to strengthen the reliability and robustness of existing reference rates and a strong case for enhancing reference rate choice. Both call for prompt action by the private and the public sector.

Several recent developments in particular have highlighted the need for changes to current reference rate practices. First, cases of market manipulation have raised concerns about the reliability of several key reference interest rates and the appropriateness of the processes and methodologies used in formulating them. Second, the sharp contraction in market activity since 2007 has raised questions about the robustness and usefulness of reference interest rates based on term unsecured interbank markets (eg Libor, Euribor, Tibor), particularly in periods of stress. In addition, structural change in derivatives markets, such as the wider use of collateral and the move to centrally clear standardised OTC derivatives transactions, may add to the demand for reference rates that do not embody bank credit risk. As a result, there is a consensus within the Group that there is demand for a range of reference interest rates that are suitable for different purposes.

These developments and the current procedures that produce reference interest rates have potential implications for monetary policy transmission and financial stability. From a monetary policy transmission perspective, reference rates may behave in unexpected ways especially in periods of stress. As a result, economy-wide financing conditions may change in unpredictable and unintended ways. Such risks could be exaggerated when market participants heavily rely on a single reference rate whose components are likely to be volatile in stressed environments. Moreover, cross-border factors may distort the relationship between monetary policy and the key reference rate(s) used in the domestic economy.

A more reliable and robust reference interest rate framework also has many potential benefits in terms of greater financial stability. First, a loss of confidence in reference rates, because they had been shown to be unreliable, could lead to market functioning disruption, especially as some contracts do not have robust fallback arrangements. Second, poorly conceived reference rates could transfer risks, particularly those related to bank funding costs, in inappropriate ways. Similarly, they could transfer pricing errors across financial markets or create greater and unnecessary basis risk. Finally, unreliable reference rates may impair the central bank's ability to respond to financial fragilities in an effective manner.

The WG is of the view that a sound framework for producing reference rates is essential for well-functioning markets. Both the private and public sectors therefore face an immediate need to ensure that reference rates are reliable and robust, and thus adequately governed and administered to appropriately guard against market abuse or systematic errors. Promoting a sound rate setting process based on greater use of transaction data combined with the transparent and appropriate use of expert judgment would enhance the resilience of reference rates. Steps should also be taken to ensure contracts have robust fallback arrangements for use in the event that the main reference rate is not produced.

This suggests an important role for the official sector in the development of commonly agreed principles to strengthen governance frameworks that enhance the reliability and robustness of reference rates. If the level of governance and administration of existing or modified reference rates are unsatisfactory, then central banks and the public sector may need to work with the private sector in the effort to create sufficiently robust and reliable reference rates and will need to stand ready to help overcome any potential barriers to their adoption. While the official sector has a role to play in developing commonly agreed principles and the strengthening of governance frameworks, choice among appropriately governed and administered reference rates should be left to private sector participants.

There is a range of possible measures central banks could take to deal with such issues. Collaborating with domestic and international regulatory bodies, central banks should work within currently ongoing reform processes to enhance the governance and administration of reference rates. Central banks should work cooperatively with relevant domestic regulators and authorities in developing guidance to encourage private entities to use sufficiently reliable and robust reference rates that are most suited for individual needs. They should also, where appropriate, work cooperatively with relevant authorities to help utilise existing regulatory and supervisory powers in evaluating rate submission processes at regulated institutions.

Market participants should have the choice between a range of reliable and robust interest rates for different uses. In particular, developing widely accepted and liquid reference rates not containing banking sector credit risk for managing exposure to interest rate risk could be beneficial. Again, the private sector should have an interest in seeking greater diversity in reference rates that better match market participants' individual needs. This includes a strong self-interest in contributing to the setting of reference rates to ensure that they are representative of actual market conditions. But there may be market failures, including network externalities, underinvestment in the production of alternative reference rates, and insufficient coordination among market participants. Moreover, there would be sizeable transition issues around any changes given the size of these markets.

Central banks have a range of options available to promote additional choices, including encouraging a rebalancing away from current mainstream reference rates which embed banking sector credit risk, and to alleviate constraints on transition. At the moderate end of the scale, they could encourage change by promoting improvements to the transparency of markets from which reference rates are derived. In order to enhance reference rate choice, central banks can promote the development and improvement of (near) credit risk free reference rates such as overnight rates and overnight index swap (OIS) rates or general collateral (GC) repo rates. Public authorities could also help bring together market participants or industry groups to coalesce around any changes and help smooth any transition. Central banks could, in some cases, even play a more active role by, for example, becoming directly involved in reference rate design and production, although robustness will ultimately depend on a sound rate setting process based on a liquid market. The actual form of involvement will depend on the extent of market failure and country- or currency area-specific circumstances, including market structures and regulatory and institutional arrangements. The issue of diversity is important, and action in this area by both the private and the public sector should start as soon as possible.