Thank you. I’d like to discuss the transition from the London Interbank Offered Rate (LIBOR).

I’d also like to talk about Hans Christian Andersen and Warren Buffett. Now you might be wondering why I’m thinking about these two men — born 125 years and an ocean apart — in the context of LIBOR. I’ll get to that in a minute.

LIBOR came together in the early 1970s so that banks could make loans with floating rates. The question was, what rate would they reference?

By the 1980s, they had coalesced around the idea of using the unsecured rate at which banks in London loaned to each other.

Over the years, LIBOR got to be so popular that it was embedded in hundreds of trillions of dollars of financial contracts around the world. Loans, derivatives, mortgages, and even supplier arrangements referenced LIBOR.

And yet, there was a problem. In good times, there was very little lending of unsecured term loans between banks — in London, or anywhere else for that matter. In stressed times, even that small market went away.

Long before the 2008 crisis, that market largely had dried up. Banks simply were not making term loans to other banks without getting some collateral in return.

That created something akin to an inverted pyramid: a massive market, worth about $220 trillion today,[1] that was referencing a market with very few underlying transactions.  

As Hans Christian Andersen wrote in his famous folktale, “The Emperor’s New Clothes”: The emperor had no clothes.

Because few transactions underpinned LIBOR, the people responsible for determining this benchmark tended to use their own judgment in setting it. That was not the only challenge. On top of that, LIBOR was easy to game.

When I was at the Commodity Futures Trading Commission,[2] the excellent staff did a remarkable job uncovering many cases of manipulative conduct at large banks. Finally, somebody had pointed out that the emperor had no clothes.

In 2013, FSOC called for U.S. regulators to take steps “to promote a smooth and orderly transition to alternative benchmarks, with consideration given to issues of stability and to mitigation of short-term market disruptions.”[3]

The Financial Stability Board recently echoed those views when it stated that “[b]enchmarks which are used extensively must be especially robust.”[4]

To that end, I have several concerns about one rate that a number of commercial banks are advocating as a replacement for LIBOR. This rate is called the Bloomberg Short-Term Bank Yield Index (BSBY).

I believe BSBY has many of the same flaws as LIBOR. Both benchmarks are based upon unsecured, term, bank-to-bank lending. Term BSBY (1-, 3-, 6-, 12-month) is underpinned primarily by trades of commercial paper and certificates of deposit issued by 34 banks. For instance, the median trading volume behind three-month BSBY is single-digit billions of dollars per day.[5] Median trading volumes for 6- and 12-month BSBY are even lower.

Thus, BSBY has the same inverted-pyramid problem as LIBOR. Like with LIBOR, we’re seeing a modest market, shouldering the weight of hundreds of trillions of dollars in transactions. When a benchmark is mismatched like that, there’s a heck of an economic incentive to manipulate it. That’s why I believe the Secured Overnight Financing Rate (SOFR), which is based on a nearly trillion-dollar market,[6] is a preferable alternative rate.

These markets underpinning BSBY not only are thin in good times; they virtually disappear in a crisis. Last spring, the primary commercial paper lending market evaporated for about five weeks during the initial stresses of the pandemic.

We just had a discussion about the lack of resiliency in prime money market funds, particularly during stress times. Let’s not forget those lessons here.

In the wake of the European debt crisis and the financial crisis, a group under the International Organization of Securities Commissions issued a report on the hygiene of benchmarks like LIBOR.[7]

This group, which I was honored to co-chair, found it was necessary to establish a benchmark that “reflects a credible market for an Interest measured by that Benchmark.”

I don’t believe BSBY meets that standard. I don’t believe it is, as FSB urged, “especially robust.”

I understand that some market participants may believe it meets that standard. At first glance, BSBY might seem like an improvement over LIBOR — a more resilient benchmark.

But make no mistake: it might look a bit different, but it’s still the same emperor. It presents similar risks to financial stability and market resiliency. 

That brings me to Warren Buffett. He’s said, “You only find out who is swimming naked when the tide goes out.”[8] I worry that a crisis will reveal BSBY’s flaws all too clearly. 

Let’s not wait for the tide to ebb to see the emperor still has no clothes.

Thank you.