Article 8.8 Fed explores overhaul ofkey rate
By Robin Harding
Financial Times July 10, 2014
The US Federal Reserve is exploring an overhaul of the Federal funds rate - a benchmark that underlies almost every financial transaction in the world - as it prepares for an eventual rise in interest rates.
The Fed funds rate is the main measure of overnight US interest rates and is based on the actual rates reported by brokers for overnight loans between US banks.
According to people familiar with the discussions, the Fed could redefine its main target rate so that it takes into account a wider range of loans between banks, making it more stable and reliable.
Concerns have grown about the reliability of the Fed funds rate since the Fed began buying trillions of dollars of assets during three rounds of quantitative easing. US banks now have huge amounts of cash and have stopped borrowing or lending Fed funds, making the market highly illiquid.
With the Fed targeting rates close to zero, the reliability of Fed funds has been less important but when the Fed starts raising rates - something markets expect it to do in the middle of next year - it needs to be sure that it is targeting a real benchmark.
In particular, the Fed is looking at redefining the funds rate to include eurodollar transactions - dollar loans between banks outside the US markets - as well as traditional onshore loans between US banks.
Other closely related rates that it could include are those on transactions for bank commercial paper and wholesale certificates of deposit between banks.
The Fed hinted at a change in the minutes of its June meeting. ‘Participants examined possibilities for changing the calculation of the effective Federal funds rate in order to obtain a more robust measure of overnight bank funding rates,' the minutes said.
Ira Jersey, director of interest rate strategy at Credit Suisse in New York, said eurodollars were a very close substitute for Fed funds.
‘In general, at nine in the morning New York time, the only difference between a Fed funds transaction and a eurodollar transaction is the back end coding,' he said.Mr Jersey said he thought including eurodollars would be unlikely to change the Fed funds rate much right now but the effect when interest rates were higher was hard to judge.
FT
Source: Harding, R. (2014) Fed explores overhaul of key rate, Financial Times, 10 July.
The US prime rate is the short-term interest rate US banks charge their best corporate customers. An average is taken from the largest US banks - the most well known is the prime rate calculated by The Wall Street Journal. In approximate terms it is around 3% more than the Fed funds rate. It is used as a benchmark for other loans, e.g. consumer credit loan interest rates are often set at so-many basis points above the prime rate, as are credit cards, home equity loans and lines of credit and auto loans. Many small business loans are also indexed to the prime rate.
Sonia and Euronia
The Wholesale Markets Brokers' Association (WMBA) is a group of financial companies which act as intermediaries (interdealer brokers) in arranging the wholesale money market operations in London. From the transactions they broker, they provide the details for calculating important benchmark interest rates for the overnight sterling and euro markets, Sonia and Euronia, all published daily at 5pm.
Sonia or SONIA (Sterling Overnight Index Average) was launched in 1997 and is a weighted average of the actual unsecured sterling overnight rates in deals in London with a size in excess of £25 million brokered by WMBA members. The weighting is by the principal amount of deposits which were taken on that day (between midnight and 4.15pm).
Euronia or EURONIA (Euro Overnight Index Average) is the UK equivalent of Eonia, a weighted average of euro interest rates on unsecured overnight euro deposits arranged by WMBA members in London. There is no minimum deal size for Euronia.
The weighting is by the principal amount of deposits which were taken on that day (between midnight and 4pm).Eurocurrency
Eurocurrency has a large part to play in the interbank market as well as other lending/borrowing markets. The terms Eurocurrency, Eurodollar, Euroyen, Euroswissfrancs, etc. have nothing to do with the actual euro currency. Their name simply means that the currency is deposited and lent outside the jurisdiction of the country that issued the currency. For example, an Australian company might make a deposit in yen in a German bank; this would be a
Euroyen deposit. An American corporation might pay a Swiss corporation in dollars; these dollars are deposited in a Swiss bank and are Eurodollars.
Today, it is not unusual to find an individual/company holding a dollar account at a UK bank which pays interest in dollars linked to general dollar rates. This money can be lent to firms wishing to borrow in Eurodollars prepared to pay interest and capital repayments in dollars. The point is that both the Euroyen deposit and the Eurodollars are outside the control of their country of origin - regulators have little influence on this market.[20] The market is a wholesale one with the minimum transaction typically $1m or equivalent in other currencies.
Growth of the Eurocurrency markets
Eurocurrency markets came about after World War II during the 1950s and 1960s, when substantial amounts of US dollars were deposited in Europe (mainly in London). Countries outside the US were wary about depositing their dollars in US banks, where they would be subject to stringent US regulations. Regulation Q of the US Banking Act of 1933 prohibited banks from paying interest on commercial demand deposits. Additionally, ‘Iron Curtain' countries were worried that their dollars could be seized or frozen for political reasons if they were placed where the rule of the US authorities was in force. Countries earning dollars, especially oil producing countries, looked for banks outside the US where they could deposit their US dollars and earn market rates of interest.
US corporations began to expand into Europe, and wanted their funds outside the control of the US authorities. Even after Regulation Q was finally phased out in the 1980s, US banks were still subject to restrictions and controls, so the Eurocurrency market thrived, where dollars could be deposited free from US regulations, although strictly speaking, the term should be international market. Nowadays, there is daily Eurosecurities business transacted in all of the major financial centres, but the most significant is London. The Bahamas, Cayman Islands and Singapore are also significant Eurocurrency centres.Eurocurrency and Eurocredit
To add a little precision: Eurocurrency is short-term (less than one year) deposits and loans outside the jurisdiction of the country in whose currency the deposit/loan is denominated. These are term (‘time') deposits that may be fixed for just one day (overnight) or for a longer period such as three months. Deals for three-month lending, for example, are struck one day and then two business days later the money is actually transferred - the spot delivery. The funds are repaid with interest at maturity three months after the spot value date (a bullet repayment structure).
Eurocredit is used for the market in medium- and long-term loans in the Euromarkets, with lending rates usually linked to (a few basis points above) the Libor rates. Loans greater than six months normally have interest rates that are reset every three or six months depending on the Libor rate then prevailing for, say, three-month lending. So a corporate borrower with a two-year loan that starts off paying three-month Libor plus 150 basis points when three-month Libor is 3% pays 4.5%. This is expressed as an annual rate - the borrower will pay only one-quarter of this for three months. If, at the start of the next three months, the three-month Libor rate has moved to 3.45%, the corporate will pay 4.95% (annual rate) for three months. Interest on deposits of more than one year is likely to be paid on an annual or six-monthly basis.
Benefits of the Eurosecurities markets
Companies large enough to use the Eurosecurities markets are able to put themselves at a competitive advantage vis-a-vis smaller firms.
• The finance available in these markets can be at a lower cost in both transaction costs and rates of return offered. There are economies of scale due to the wholesale nature of the market. The absence of withholding tax on interest and anonymity encourage lenders to offer lower rates.
• There are fewer rules and regulations, such as needing to obtain official authorisation to issue or needing to queue to issue, leading to speed, innovation and lower costs.
• There may be the ability to hedge foreign currency movements. For example, if a firm has assets denominated in a foreign currency it can be advantageous to also have liabilities in that same currency to reduce the adverse impact of exchange rate movements.
• The borrowing needs of some firms are simply too large for their domestic markets to supply. To avoid being hampered in expansion plans, large firms can turn to the international market in finance.
The Eurocurrency market allows countries and corporations to lend and borrow funds worldwide, picking the financial institution which is the most suitable regardless of geographic position. While the world economy is thriving, this works well. However, some spectacular problems were highlighted in 2008. For example, Iceland's financial institutions found themselves in trouble after much of their borrowing in the international debt markets suddenly dried up.
The Eurodollar market has become so deep and broad that it now sets interest rates back in the mother country of the dollar. A very large proportion of US domestic commercial loans and commercial paper interest rates are set at a certain number of basis points above US dollar Libor rates determined by banks operating out of London.