The Dollar Is a Global Currency - Now More Than Ever
Central banking systems like the Federal Reserve set interest rates that the public ultimately pays on its debt, loans and mortgages. They raise or lower short-term rates, stipulating bank reserve requirements, and establish a “floor” by paying interest on those reserves held in the banking system. That process describes interest rate setting in a national context. But as we know, finance is now global, capital controls continue to diminish and dollar lending takes place in practically every major financial jurisdiction on the planet. As dollar funding became globalized, there grew a desire for an international benchmark, out of which evolved the London Interbank Offered Rate (LIBOR), a lynchpin that has been used as the reference point for everything from credit card rates to student loans, mortgages, and international borrowing, especially for the multitrillion-dollar interest rate derivative contracts.
Of course, as we now know, there was nothing “market-based” in the setting of the LIBOR. In fact, the bankers and related institutional investors engaged in sustained efforts to manipulate the rate to benefit the profitability of their own institutions, literally costing borrowers hundreds of billions of dollars in fees as a consequence of this collusive behavior.
The main banks involved in setting these artificially derived rates were a cartel, which conspired to manipulate LIBOR and not only lied about it but also covered up the cartel and the fraud scheme that was used. This game became exposed in the aftermath of the 2008 financial crisis when the U.S. Department of Justice, the UK’s Serious Fraud Office, and a host of other global regulatory bodies began to scrutinize more closely the practices of the global banking behemoths, such as UBS, HSBC and Citigroup.
So it may come as some surprise to many that LIBOR is still the benchmark for this multiplicity of functions, even as many of the bankers and investors responsible for its manipulation have gone to jail or have faced huge penalties, some of the largest from the overall $320 billion in misconduct fines since the financial crisis. Many of the world’s large financial institutions are signed on with LIBOR until 2021, at which point they may turn to the Secured Overnight Financing Rate (SOFR), which is now being published by the New York Federal Reserve, as the first in a series of steps to enable a transition from LIBOR.
Given the existing taint of criminality, replacing LIBOR makes sense. What is harder to justify is that many of the very same institutions found complicit in the LIBOR manipulation scandal are the main players being tasked to find and market its replacement. This has been a pretty standard modus operandus when it comes to implementing changes in the wake of the 2008 crash, namely deferring to the interests/preferences of Big Finance. Virtually no inputs are coming from the parties adversely affected by the scandal, nor from policy-makers, regulators or academics with a credible track record of genuine financial reform. The justification being offered is that the banks are now subject to far greater regulatory scrutiny than was the case before the scandal was uncovered (that’s doubtful given the U.S. Justice Department’s questionable claim that imposing criminal charges on the offending banks—as opposed to individual bankers—would endanger financial stability, as well as the fact that the Trump administration seems hellbent on rolling back any form of financial regulation).
The other claim made in favor of retaining LIBOR for now is that to drop it immediately in the absence of a viable, liquid alternative would bring considerable costs and risks for financial firms on the grounds that any new benchmark would require changes to the banks’ “value at risk” models, valuation tools, product design and hedging strategies. That may be more justifiable, but as Yves Smith, publisher of the economics blog Naked Capitalism, cautions, “a widespread failing in the United States is the degree to which banking authorities treat their charges with undue deference,” which means that the regulators should take the banks’ recommendations with a grain of salt, given the level of self-interest and historic self-dealing.
Nevertheless, in light of LIBOR’s loss of credibility as a benchmark rate due to attempted market manipulation, false reporting of global reference rates and the decline in liquidity of interbank unsecured funding markets, any move from LIBOR is to be welcomed. With that in mind, the Financial Stability Board (FSB) has been rightly tasked by the G20 to review the major interest rate benchmarks and plan their reforms accordingly.
As noted earlier, the most notable alternative is one being championed by the NY Fed, in combination with group of large banks, the Alternative Reference Rate Committee (ARRC). They have proposed an alternative rate, the Secured Overnight Financing Rate (SOFR). SOFR would be based on transactions in the Treasury repurchase market (in finance-speak, the so-called “repo rate”), whereby banks and investors borrow or loan Treasuries overnight, thus according a central role to the Federal Reserve, instead of a global cartel of 16 international banks from a variety of national jurisdictions. SOFR futures on the Chicago Mercantile Exchange are now being offered (to enhance its liquidity), but challenges remain, notably the paucity of trading infrastructure, development of liquid term structure from an overnight rate, educating stakeholders, hedge accounting eligibility, and legacy LIBOR portfolios.
There is also some suspicion that political considerations are behind the NY Fed’s new proposal, insofar as SOFR, the American-based alternative, is in part seen as preserving dollar hegemony, in part exploiting London’s potential weakness as a future global financial center as a consequence of Brexit and the corresponding fallout with the European Union.
However high-minded or self-interested the proposed reforms might appear to be, the fact is that what the NY Fed is proposing is no longer the London Interbank Overnight Rate, but an alternative American-dollar-based rate.
The dollar is the global currency, goes the implicit argument. So why not have the central bank issuer be in the business of setting a global overnight rate? The champions of this proposal would no doubt suggest that SOFR would mark yet another stage of maturity of central banks working in concert increasingly leading to one global financial mechanism, especially given that the vast bulk of international lending is still dollar-denominated.
Whether they choose to acknowledge this explicitly or not, from the Fed’s perspective, it effectively entrenches them as the global central banker. Under the current system, foreign central banks generally intermediate on dollar transactions on behalf of their individual nations (hold some dollar reserves or treasuries for that purpose), whereas the Fed has historically acted as lender of last resort to its foreign counterparts, one stage removed from the specific commercial transactions at hand. That changes under SOFR, which is directly tied to Treasury repo transactions.
There are other reform proposals. Reuters reports that “a British committee last year selected SONIA, an unsecured overnight lending rate, as an alternative to sterling-based Libor and Japan selected TONAR as an alternative to yen Libor, also an unsecured rate. A group in Switzerland selected SARON, a collateralized rate based on the Swiss repo market.” (Fans of The Lord of the Rings will no doubt appreciate the irony of the Swiss acronym.)
These alternatives might well have a role to play in some limited way, but why would dollar borrowers wish to use sterling, yen or Swiss franc based repo rate, rather than a dollar-sourced funding reference rate?
Additionally, what these counterproposals conveniently ignore is that there is no longer a reason for multiple global centers of dollar lending. It is worth recalling that LIBOR is in fact an offspring of the euro-dollar market, which emerged in London as a consequence of the combined impositions of Regulation Q and the interest-rate equalization tax in the U.S., both of which had the effect of limiting the rates that could be paid to onshore dollar depositors, whether domestic or foreign (primarily in order to protect the great number of small U.S. banks that constituted the American banking system), resulting in a migration of dollar lending to London, which had less onerous restrictions and costs. The 2010 passing of the Dodd-Frank Bill in the U.S. effectively repealed Regulation Q and has therefore allowed for banks to offer interest on checking accounts for its business banking customers globally.
In that sense, LIBOR is now an orphan. Its parentage has been legislated out of existence and the “offspring” of Regulation Q have been shown to have behaved abominably. And the competing international alternatives won’t work, to the extent that these global financial transactions are dollar denominated (as opposed to Swiss franc, yen, yuan, or sterling-based transactions, for which there might be a role, for the other proposals, albeit considerably smaller). To the extent that any of these other financial centers wishes to encourage alternatives to dollar lending, they must be willing to provide substantially greater opportunities to net save in a foreign currency, which means running up persistent current account deficits so that foreigners can more easily accumulate, say, additional euros, francs, yen or sterling. That kind of practice remains anathema to the likes of mercantilist countries such as Germany or China, which creates hurdles to opposing dollar hegemony straight off the bat.
The broader problem in regard to replacing LIBOR is that it starts from the presumption that the broader financial architecture in which it (and its proposed successor, SOFR) exists and operates is sustainable and not in need of substantial repair. The groups consulted on this matter are exclusively the mega-financial institutions (which are generally multiples of national GDP), which were the architects of the 2008 crisis. Nowhere are the consumers of such products being asked for input, even though such entities were the main casualties of the bankers’ malfeasance.
In effect, the inmates are being asked to run the asylum or, at the very least, set up the rules for the central bankers, who may still be too prone to regulatory capture. They are being asked to establish a benchmark for trillions of dollars of complex and relatively opaque derivatives, which, as the LIBOR experience has illustrated, can be used to mask market manipulation, customer deception and outright fraud. Greater efforts should be made to ensure that banks serve their original role as promoter of the capital development of the economy, of which the replacement of LIBOR with SOFR (or some other benchmark) should be but a feature, not a central focus of broader financial reform.