Federal Reserve Endorses Ethereum-Backed Alternative To Libor

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Federal Reserve Board Chairman Jerome H. Powell provided a statement on May 28, 2020, regarding the suitability of AMERIBOR as a replacement to LIBOR. AMERIBOR uses a permissioned version of Ethereum blockchain to capture the interbank lending rates.

The written statement dated May 28, 2020 was in response to a “question for the record” from Senator Tom Cotton (R-AR) following Chairman Powell’s testimony to the U.S. Senate’s Committee on Banking, Housing, and Urban Affairs held on February 12, 2020. Senator Cotton asked if the Fed supports alternative benchmark interest rates besides the Secured Overnight Financing Rate (SOFR) – such as AMERIBOR – for the replacement of LIBOR.

ScribdChair Powell to Sen. Cotton 5.28.20

Senator Cottons question was printed in a letter received by Forbes Crypto that asks, “In today’s hearing, you spoke about the transition from LIBOR and how a number of banks have said they’d like to work on a rate that is separate from SOFR, i.e. a rate that is credit-sensitive (as is LIBOR). I was glad to hear you mention that the Federal Reserve is working with those banks to support their efforts to use a credit-sensitive rate. Is Ameribor appropriate to use for institutions for whom it more accurately represents their cost of funding?”

Chairman Powell stated in his response that, “the Federal Reserve convened and supports the work of the Alternative Reference Rates Committee (ARRC) and views SOFR as a robust alternative that will help many market participants in the transition away from LIBOR. However, we have been clear that the ARRC’s recommendations and the use of SOFR are voluntary and that market participants should seek to transition away from LIBOR in the manner that is most appropriate given their specific circumstances.”

Chairman Powell further stated in his letter, “AMERIBOR is a reference rate created by the American Financial Exchange based on a cohesive and well-defined market that meets the International Organization of Securities Commission’s (IOSCO) principles for financial benchmarks. While [AMERIBOR] is a fully appropriate rate for the banks that fund themselves through the American Financial Exchange (AFX) or for other similar institutions for whom AMERIBOR may reflect their cost of funding, it may not be a natural fit for many market participants.”

The London Interbank Offered Rate (LIBOR) is a widely used benchmark for short-term interest rates that was hit with a series of scandals that surfaced where bankers had been manipulating the lending rates based on $300 trillion in contracts that led to billions of dollars in losses for local municipalities in the U.S.

As a result, the Federal Reserve Bank of New York President John Williams last year said the finance industry “must not wait” to stop using the LIBOR lending benchmark. The Federal Reserve convened the Alternative Reference Rates Committee (ARRC) that created the Secured Overnight Financing Rate (SOFR) as an alternative to LIBOR. SOFR is a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities.

Use Of Permissioned Ethereum With AMERIBOR

AMERIBOR uses an emerging technology called blockchain as part of its determination of the rates and is seen as a strong competitor to SOFR. “This is AFX’s first major blockchain initiative,” said AFX chair and CEO Richard Sandor, in a statement. “We learned a great deal about this new and exciting technology and believe the blockchain has the potential to transform electronic trading and financial markets. AFX is committed to remain in the forefront of this new technology.”

AFX will mint two non-fungible tokens for each party in a transaction. Unlike bitcoin, which is fungible, meaning every token is the same, these non-fungible tokens, compliant with the ERC-721 token standard, contain information about the transaction and the counterparty. The tokens are automatically minted by the AFX Blockchain when a transaction begins, and, using the parity smart contract language, are automatically settled when the transaction ends. 

Unlike transactions on the public Ethereum blockchain, which reach consensus through a process called proof-of-work that anyone can participate in, the AFX Blockchain uses proof-of-authority, meaning that while the tokens will be compatible with the public blockchain, AFX maintains a degree of control over the transactions.

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The AMERIBOR blockchain will mint two non-fungible tokens for each party in a transaction. By the fact that each token is fungible or different, the token will contain information about the transaction and the counterparty on the distributed ledger. AFX uses an enterprise version of Ethereum, meaning the recording of these transactions is not done on the public Ethereum mainnet; however, AFX could choose to transfer over the results to the public while protecting the identity of the counterparties.

Federal Reserve And Blockchain Technology

In 2016, Federal Reserve Governor Lael Brainard, who has been following blockchain technology for quite some time for the Fed, stated, “We recognize the potential of distributed ledger technology, or blockchain, to transform the way financial market participants transfer, store, and maintain ownership records of digitized assets.” Brainard did say it was an emerging technology that still needed to be proven. The Boston Fed has been working silently on blockchain since 2016 and conducted an experiment last year with Ethereum and Hyperledger in a proof-of-concept.

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The Federal Reserve as a regulator cannot ignore the trend in how billion dollar companies are experimenting with and using blockchain technology, so it is natural that as private-sector adoption increases, the central bank will keep an eye on these trends and adapt to how the marketplace and banks start using the technology.

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