Fed May Pick Offshore Rate To "Fix" Fed Funds Market

While the new reference rate would be important simply by dint of underpinning trillions of dollars worth of derivatives contracts, its significance could go much further. Fresh research from Credit Suisse Securities USA LLC suggests the chosen rate could also become the new target rate for the Federal Reserve, replacing the federal funds rate that has dominated money markets for decades but has been neutered by recent regulation and asset purchase programs.

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While the Fed is faced with a fed funds target rate that's fading into irrelevance, the ARRC has been eyeballing two alternative rates as it seeks to replace untrustworthy Libor. The two are the Fed's new overnight bank funding rate (OBFR) and the overnight U.S. Treasury general collateral repo rate. The OBFR, which mixes fed funds with overnight eurodollar deposits to come up with an average cost of funds for U.S. banks, has emerged as the front runner in recent weeks±gaining support from at least one prominent financial industry body last month.

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To avoid the complications associated with this path, the Fed could settle in on the repo rate as its new policy target.

But here Pozsar also sees potential problems: "Switching to a repo rate won't be simple either. In fact, it is impossible at present. Why? Because primary dealers do not have access to the discount window and so there is no ex-ante mechanism in place that would enable the Fed to cap repo rates in a crisis. And if you can't cap it, you can't target it."