Understanding the New Interest Rate Benchmark Regime — Part I
This article is the first amongst a series of articles that I plan to write over the next few weeks to discuss the new interest rate benchmarks regime that is set to debut in the year 2021.
We often hear the term benchmark in our everyday lives. Benchmark is perceived as a standard or a reference marker in its respective field of application. For instance, a few commonly used benchmarks that come to my mind are:
a. Consumer Price Index (CPI): This is the reference for the current level of inflation in the economy.
b. Brent Crude benchmark: Based on the type of crude oil, there are benchmarks set for each of the types. These respective benchmarks act as a reference for the crude oil prices.
c. Interest rate benchmarks: There are a host of interest rates that get quoted in the market. Each of these rates serves a specific purpose. A simple example is the benchmark sovereign yield curve. Generally, this corresponds to the yield quoted on a sovereign bond with maturity of 10Y. This rate sets the tone for other associated rates in the economy. Another example are the Libor rates that get quoted in the market and which acts as a reference rate for various financial products trading in the market.
Each of the above benchmarks are designed to meet specific requirements of the market. Investors keep an eye on such benchmarks because they have an impact on their portfolios, whereas Regulators keep track of such benchmarks to aid in policy decision making which defines the course of the economy.
In this post, we begin with discussing history of interest rate benchmarks, the problems that are observed in the existing set of benchmarks, why benchmark rates are so important and finally talk briefly about the approach for the new benchmark regime.
Benchmarks — How they have traveled historically
In the mid to late 90s, US treasury bill rates (also referred to “T-bill”) were used as benchmark rates for various financial transactions. Up until the year 1986, the market was using these T-bills as a proxy for the rates in the market. However, there was a growing sense of motivation amongst market participants to shift from risk free rates like the T-bill rate…