By Katy Burne and Ben Eisen

Efforts to replace the compromised Libor financial benchmark are running into their own problems, in part thanks to new rules governing money-market funds.

Libor, a survey of overnight bank borrowing costs that's linked to $350 trillion of complex derivatives and trillions of dollars in loans to consumers, companies and governments, lost credibility during an industrywide rigging scandal several years ago. Banks were found to have manipulated the benchmark for their own gains.

Since 2014, market overseers have been pushing the industry to come up with a credible replacement for U.S. dollar Libor. One strong candidate has been the Overnight Bank Funding Rate, a new benchmark devisedby the Federal Reserve as a comprehensive measure of overnight bank borrowing costs.

But since it was introduced in March, the rate, known as OBFR, has been beset by slumping trading volume. Lower volumes stand to make the rate less useful as an indicator of demand for funds, traders and analysts say -- an important consideration for its future role.

It is the latest setback for regulators' efforts to replace the tainted Libor benchmark with a new measure that will more accurately depict conditions in short-term lending markets. The overhaul has been complicated by regulations that have dampened lending to banks and the limits on regulators' capacity to impose a new gauge by fiat.

The daily volume of trades used to compile the Fed's OBFR has halved since May to $157 billion as of Nov. 4, central-bank data show. Lower volumes partly reflect a decline in eurodollar transactions, U.S. dollar-denominated deposits held at banks or bank branches outside the U.S. that are roughly half of the OBFR rate calculation. The other half uses trades in the federal funds market that make up the official U.S. interest-rate-policy benchmark.

Declines in eurodollar transactions are being attributed in part to new restrictions on U.S. money-market funds that took effect last month and aim to prevent a recurrence of the 2008 run on such funds. The rules have driven investors away from "prime" funds that historically have invested in a range of debt, toward funds that invest in government bonds and therefore aren't subject to new restrictions.

One result has been shrinking borrowing by offshore banks from prime funds in the eurodollar market. The OBFR rate has risen since early October to 0.41% from 0.40%. Meanwhile, three-month U.S. dollar Libor has risen to its highest level since the financial crisis, as European and Japanese banks have paid more to borrow.

For regulators, the idea that OBFR might not be ready to meet the challenge of replacing Libor is no small problem. Some firms have withdrawn from Libor panels in recent years. BNP Paribas SA left the U.S. dollar Libor panel in August, said people familiar with the matter. That is one reason for regulatory angst about having an alternative in place soon if Libor once again runs into trouble.

"While Libor risks may not feel urgent now, the best time to transition is before any problems with Libor reach a critical point," said Daleep Singh, the Treasury Department's acting assistant secretary for financial markets, in a speech on Oct. 20.

For years, banks setting Libor agreed to submit individually to an industry body based on what rate they believed they would pay to borrow across a range of currencies and maturities. Typically, their submissions weren't based on what they actually paid to borrow but rather on their judgment of lending market conditions that day.

After banks were charged during the financial crisis with rigging the rate, leading to a wave of costly lawsuits, regulators embarked on an overhaul. A unit of Intercontinental Exchange Inc. took over administration of the rate in 2014. The changes also stipulated that the rate should be backed up in part by real-life transactions, not broker quotes.

Many bank employees who submit transaction rates into Libor are now physically segregated from traders and sit inside lenders' corporate treasury departments, traders said. The ring fencing is designed to prevent information sharing, but it has also made banks leery of helping to set Libor because doing so holds greater legal risks and fewer rewards.

Roughly 30% of Libor submissions for the three-month U.S. dollar rate are now based on actual transactions, according to the Treasury. Finbarr Hutcheson, head of ICE Benchmark Administration, which oversees Libor, said "a new rate would have to be a significant improvement on where Libor is today."

In May, a Fed-sponsored industry committee proposed two alternatives. One is OBFR. The other is a blended rate of short-term loans called "repurchase agreements" secured by U.S. Treasury bonds. This "repo" rate, as envisaged, has never been calculated before but on Friday the Federal Reserve Bank of New York announced three new repo benchmarks that fit the bill, and likely will be published starting in late 2017 or early 2018.

The final decision by the industry committee on choosing a new benchmark is expected to take several months, and implementation would take even longer.

A spokeswoman for the New York Fed, which convenes the committee, declined to comment.

End users of Libor, including large investment firms such as BlackRock Inc. and Pacific Investment Management Co., are being encouraged to form a subcommittee to advise on any finaldecision made by the banks, according to two people familiar with the matter.

"I think they would be best suited by moving carefully given the herculean task of trying to shift the market away from Libor," said Mark Cabana, head of U.S. short-term interest-rates strategy at Bank of America Merrill Lynch.

Write to Katy Burne at katy.burne@wsj.com and Ben Eisen at ben.eisen@wsj.com

(END) Dow Jones Newswires

November 07, 2016 12:58 ET (17:58 GMT)

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