The Bank of Korea and Financial Services Commission in Unison on 'Expanding KOFR Share'... What is KOFR? [BOK Focus]

Domestic Risk-Free Benchmark Interest Rate Developed After Libor Scandal
Developed to Overcome Limitations of Existing Reference Rate CD Rate
"Interest Burden Reduction and Enhanced Monetary Policy Effectiveness Expected"

"The Bank of Korea and the Financial Services Commission aim to transition to an indicator interest rate system centered on KOFR. They actively recommend that financial institutions use KOFR as the benchmark rate for derivatives and spot products."

Bank of Korea Governor Lee Chang-yong and Financial Services Commission Vice Chairman Kim So-young are attending the policy conference on "Key Tasks and Future Directions for Activating the Domestic Risk-Free Reference Rate (KOFR)" held at the Bank of Korea in Jung-gu, Seoul on the 28th, exchanging opinions. Photo by Kang Jin-hyung aymsdream@

On the 28th, the Bank of Korea and the Financial Services Commission held a joint conference and agreed that KOFR (Korea Overnight Financing Repo Rate) should be established as the benchmark interest rate for loans and various financial derivatives instead of the Certificate of Deposit (CD) rate. The CD rate, which has been used as a benchmark interest rate, has been criticized for not accurately reflecting market interest rates and for being calculated based on quotes, which raises concerns about collusion or manipulation. In contrast, KOFR is calculated based on actual transactions, making manipulation or collusion difficult, and it maintains a level similar to the base interest rate, thus more accurately reflecting market interest rates.

KOFR is South Korea's risk-free reference rate (RFR) calculated using the overnight repurchase agreement (RP) rate secured by government bonds and monetary stabilization bonds. Government bonds refer to treasury bonds, and monetary stabilization bonds are securities issued by the Bank of Korea to regulate the money supply when there is too much or too little money circulating in the market. An RP means that securities companies or banks borrow money using these bonds as collateral. Overnight means a one-day interest rate, i.e., borrowing today and repaying tomorrow. Because the collateral is secure and there is usually little change in the interest rate within a day, it is considered safe. KOFR is called the safest "risk-free rate" because it is an overnight RP rate secured by government bonds and monetary stabilization bonds. When KOFR is used as a benchmark interest rate, banks add a spread to the KOFR rate to create various financial products.

Introduction of Risk-Free Reference Rates after the 2012 LIBOR Scandal

Risk-free reference rates began to be introduced worldwide after the 2012 LIBOR (London Inter-bank Offered Rates) scandal. LIBOR was the interbank interest rate in London, UK, and was used as a representative benchmark rate in the international financial market, often called the "benchmark of benchmark rates." However, it was revealed that some major banks manipulated and colluded by deliberately submitting high quotes on the loan interest rate determination date, exploiting the vulnerability of LIBOR, which is based on quotes, thus losing credibility. Subsequently, major advanced countries such as the United States and the United Kingdom developed and began using new benchmark rates called risk-free reference rates (RFR) to replace LIBOR. Currently, countries like the US, UK, and Switzerland apply RFR to more than 90% of interest rate derivative transactions.

South Korea has also selected KOFR as the domestic risk-free reference rate in February 2021 in line with global trends and has been calculating and publishing it. However, KOFR has not been established as the benchmark interest rate, and most financial transactions are still based on the CD rate. The CD rate has long been pointed out to have many structural limitations as a benchmark interest rate. Despite various institutional improvements, the trading volume is insufficient, limiting its ability to accurately reflect the actual supply and demand of funds. In fact, there are many days when no CD (80-100 day maturity) issuance, which serves as the basis for rate calculation, occurs, forcing individual financial institutions to calculate rates based on their own judgment.

Moreover, the CD rate shows rigidity by not sufficiently reflecting the decline in other market interest rates during a falling interest rate period, while it rises excessively when market instability highlights credit risk. This works disadvantageously for financial consumers. Overseas investors have also consistently raised opinions that the practice of using the CD rate as a benchmark interest rate does not align with global financial transaction standards and needs improvement.

Benefits to Financial Consumers and Enhanced Monetary Policy Effectiveness with KOFR as Benchmark Rate

Accordingly, the Bank of Korea and the Financial Services Commission launched a private working group in March, including related organizations and market participants, to transition the benchmark interest rate to KOFR. They proposed a three-step plan for the transition: first, establishing the technical foundation for KOFR expansion; second, setting periodic KOFR usage targets led by the Financial Services Commission, the Financial Supervisory Service, and the Bank of Korea to increase market share; and third, delisting the CD rate as an important benchmark to complete the benchmark interest rate reform.

If KOFR is established as the benchmark interest rate, the predictability of interest rates will increase, enhancing the benefits to financial consumers. For banks handling loans, it will be possible to directly compare the spreads of KOFR loan products offered by each bank, promoting competition among banks and thereby improving consumer utility. Additionally, once KOFR loan products are launched, consumers will be able to compare them with other loan products linked to rates such as COFIX and bank bonds, allowing consumers to better assess and choose favorable interest rates, thus diversifying interest rate options.

The effectiveness of monetary policy is also expected to improve. Since KOFR's calculation began, the average spread relative to the base interest rate is 0.9 basis points with a standard deviation of 12.8, whereas during the same period, the CD rate's average spread relative to the base interest rate is 28.1 basis points with a standard deviation of 22.7. KOFR is an overnight RP rate determined in the ultra-short-term market where monetary policy transmission begins, so unlike the CD rate, it does not deviate significantly from the Bank of Korea's base interest rate level.

At the event, Vice Governor Kim So-young said in her congratulatory remarks, "The expansion of KOFR rates is no longer a matter of choice but a matter of urgent action to produce results," and urged, "Let the financial authorities, the Bank of Korea, and the financial sector unite to establish new market practices."

Bank of Korea Governor Lee Chang-yong said at the conference, "The transition to KOFR is very important for the effectiveness of monetary policy," adding, "The Bank of Korea is also pursuing measures such as extending forward guidance from about three months to one year and expanding eligible collateral to manage collateral and induce the expansion of the derivatives market."