IGTA Journal - Summer 2018

William C Dudley: The transition to a robust reference rate regime Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the Bank of England’s Markets Forum 2018, London, 24 May 2018. * * * Thank you, Mark, and thanks to the Bank of England for the opportunity to talk about the important issue of reference rates. I will focus my remarks today on reference rate reform in the United States—where we have been, where we are, and where we are headed. In short, I will argue that while much has already been accomplished, we still have a lot more to do—and it must happen within a compressed time frame. This is an important point that Andrew Bailey usefully underscored for us last year. Because of the great uncertainty over LIBOR’s future and the risks to financial stability that would likely accompany a disorderly transition to alternative reference rates, we need aggressive action to move to a more durable and resilient benchmark regime. As always, what I have to say reflects my own views and not those of the Federal Open Market Committee (FOMC) or the Federal Reserve System . LIBOR Scandal Demonstrated the Imperative for Reform Although the backdrop to current reference rate reform efforts is well known here, some historical context is useful when considering the issues facing us today. That history highlights why alternatives to LIBOR are needed. It also illustrates the importance of continuing to focus on bank culture and proper incentives in order to support financial stability over the longer term. At its core, the problem we face today is that the financial system has built a tremendously large edifice on a structurally impaired foundation. While many in the industry cannot recall a time when LIBOR did not exist, in fact, it was only developed in the 1980s. Since then, the use of LIBOR as a reference rate has exploded—with the size of financial contracts referencing U.S.- dollar LIBOR today estimated at close to $200 trillion . The vast majority of these exposures are derivative obligations, such as interest rate swaps. But, that tally also includes trillions of dollars of cash products, such as residential and commercial mortgages, corporate bonds and loans, and securitized products. And, with new contracts referencing LIBOR still being written, this balance continues to grow significantly. Broadly speaking, reference rates are vital to efficient market functioning. They facilitate trading in standardized contracts, which lowers transaction costs and increases market liquidity. Robust reference rates can also reduce information asymmetries and the risk of misconduct by providing transparent, independent pricing. But, in the case of LIBOR, the foundation had serious flaws. Most notably, LIBOR was (and is) based on submissions from individual banks—which, in turn, were based on hypothetical borrowing rates or expert judgments, and not actual transactions. Moreover, deficiencies existed in regulatory oversight and governance of the rate-setting mechanism. These vulnerabilities enabled the manipulation of the rate for the financial benefit of individuals and institutions. Amid profound breakdowns in controls and compliance, individual traders conspired with rate submitters at their own institutions or traders at other firms to manipulate the setting of the rate to improve their trading results. During the global financial crisis, panel banks also reportedly submitted lower borrowing rates than they could actually obtain in the marketplace. They did so to disguise their financial fragility at a time when uncertainty over bank liquidity and solvency was high . The resulting scandal was particularly disturbing because of its scale and flagrancy, including collusion by employees across firms. It led to billions of dollars in fines, jail terms for some individuals, and severe reputational damage to the financial industry as a whole. The global 1 2 3 1 / 6 BIS central bankers' speeches IGTA eJournal | Summer 2018 | 46