Change is never easy. And when you’re looking for a change that upends the way the global financial system functions, it may seem downright impossible.
In the decade following the 2008 financial crisis, however, the global financial industry – in particular, the cleared derivatives industry – has shown itself capable of transforming in big ways. Some of these changes were a forced response to regulation and others were the latest ideas from an industry with a rich history of innovation, but collectively these changes show derivatives markets are dynamic and resilient in the face of adversity.
The big changes prompted by the crisis aren’t quite behind us yet, however.
Thanks to evidence of attempted manipulation in key global reference rates along with a steep decline in interbank lending, international standard-setters began talking about the importance of benchmark reforms as early as 2013. That year, the Financial Stability Board issued a report asserting that “the official sector has an essential role to play in ensuring that widely-used benchmarks are held to appropriate standards of governance, transparency and reliability,” and IOSCO issued a consultation on the “Principles of Financial Benchmarks.”
Efforts at benchmark reform took on a true sense of urgency in 2017, however, after the U.K.’s Financial Conduct Authority announced plans to look beyond Libor – perhaps the most popular benchmark rate on the planet – by 2021. Long used as the global benchmark to represent borrowing costs between banks, roughly $350 trillion of financial products are tied to this benchmark at present across different currencies and geographies – including CME’s Eurodollar futures, which are one of the largest and most successful interest rate-based contracts on the planet and saw volume north of 765 million contracts in 2018.
Replacing legacy benchmarks, launching new products and moving existing liquidity are no easy tasks. There’s a real risk of market disruption as the current regime of interbank rates supports a host of products for lenders and borrowers as well as derivatives that provide robust liquidity and transparency for those looking to efficiently manage their exposures to interest rate risk.
There are big opportunities for those who rise to the occasion, however. From exchanges creating new derivatives contracts to service providers supporting these new products to portfolio compression services that reduce the number of legacy contracts, there is a host of new business to be won amid this major transition.
So what challenges remain in moving markets to this new generation of reference rates? And how prepared is the global financial system as we approach the end of Libor in 2021?
The Next Generation of Reference Rates
Global financial markets are vast and complex, and there are rarely one-size-fits-all solutions. So even though Libor is the biggest and most prominent rate undergoing a transformation, it is hardly alone.
A number of working groups comprising representatives from both private industry and the official sector have been formed around the world to discuss alternatives to legacy rates – and each constituency has developed its strategy based on local currencies and policy priorities.
- In the U.S., the Federal Reserve Bank of New York convened the first meeting of an Alternative Reference Rates Committee (ARRC) in 2014. The ARRC has since recommended the Secured Overnight Financing Rate (SOFR) as a USD Libor alternative, and in 2017 it published a Paced Transition Plan with specific steps and timelines to encourage its adoption.
- In 2016, the Bank of England took over administration of the Sterling Overnight Night Index Average (Sonia), a reference rate for overnight unsecured borrowing among banks in the sterling market. Together with the Financial Conduct Authority, the Bank of England began working with industry in 2017 to facilitate a transition to Sonia as the primary interest rate benchmark in sterling markets.
- The Bank of Japan established its Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks in August 2018 to help market participants appropriately choose and use Japanese yen interest rate benchmarks. The group is facilitating adoption of the Tokyo Overnight Average Rate (TONA) in place of Libor and its sister Tibor – the Tokyo Interbank Offered Rate.
- In Switzerland, the National Working Group on Swiss Franc Reference Rates has put forth the Swiss Average Rate Overnight (Saron) as an alternative for derivatives, loan and deposit markets.
- In Europe, a Working Group on Euro Risk-Free Rates including financial institutions, asset managers and trade associations has been working on a recommendation for a new risk-free reference rate. After public consultation, the group recommended in 2018 that the Euro Short-Term Rate (€STR) be used as the risk-free rate for the euro area instead of the current euro overnight index average (Eonia) and began focusing on supporting the market with transitioning.
These alternative reference rates are similar insofar as they are aiming to act as improved benchmarks in a post-crisis world. However, they all present their own unique challenges.
Given all the various currencies, rate methodologies and data to digest, it can be hard to get a handle on the full scope of benchmark reform. However, there are several key topics that all derivatives markets participants should watch as we begin to see new products emerge and approach the potential sunsetting of Libor and other key rates in the near future.
A Need for Clarity and Deadlines
In the case of SOFR in the U.S. and Sonia in the U.K., regulators telegraphed early on their intentions to move markets away from Libor. By proactively establishing working groups to drive the conversation and wielding the subtle soft power of prudential regulators, both jurisdictions have sent clear intentions to the market, said Andy Ross, CEO of Curve Global.
“I complement what the ARRC and the Fed has done creating clarity around expectations, and we’ve seen the great work from the Bank of England working groups as well,” said Ross. “As a result we have an understanding of Sonia and how that market can grow. It’s not a question of if but when.”
Things are different in the euro zone, however.
“With €STR it’s a much more difficult conversation because there has been both a stick and a carrot approach by prudential regulators elsewhere, but in Europe I’m not sure there’s either a stick or a carrot just yet.”
Andy Ross
CEO, Curve Global
“With respect to European benchmark reform, in OTC terms we’re talking about a change to the discount rate vs. a change to the forward rate,” said Chris Rhodes, Global Head of Financial Derivatives at ICE Futures. “In a swap you have the forward rate that is usually an IBOR and the discount rate which in the case of sterling is Sonia or in dollars Fed Funds. But in euros you have a forward rate that is Euribor and a discount rate of Eonia. So what €STR is trying to do is to replace Eonia – not necessarily the forward rate – and this completely changes the complexion of benchmark reform in Europe as a result.”
While the ECB formally endorsed €STR as the alternative to Eonia as the discount rate and has set a deadline of October 2019 to transition to the new benchmark, details are lighter on its plans for Euribor as a forward rate. A transition away from that unsecured benchmark was initially scheduled for January 2020 but was recently postposed to 2022.
This creates two challenges: the first being simple uncertainty around any Euribor alternative, and secondly that market participants will not act with urgency after the delay as they see benchmark reform deadlines as suggestions instead of hard cut-offs for legacy rates.
“In Europe, they haven’t 100% defined the new standard yet and haven’t prescribed clear plans on how to move from the old to the new,” Ross said. “With €STR it’s a much more difficult conversation because there has been both a stick and a carrot approach by prudential regulators elsewhere, but in Europe I’m not sure there’s either a stick or a carrot just yet.”
Matthias Graulich, chief strategy officer and executive board member at Eurex Clearing, shared some of these concerns.
“If Eonia remains compliant with regulation, then liquidity would probably be very hard to move to any €STR products. Liquidity tends to be very sticky, and making liquidity switch from one benchmark to another requires the clear end of an existing benchmark,” Graulich said. “That is where guidance from a regulator is critical. When there is no clear deadline or target for transition, there’s a risk people bet on postponement.”
Real Rates Mean Real Volatility
One of the biggest challenges with some Libor alternatives is that by being benchmarked to real-world transactions, they also expose real-world quirks in financial markets.
For instance, SOFR is “a broad measure of the cost of borrowing cash overnight collateralized by Treasury securities,” according to the New York Fed. On the plus side, it is secured and based on actual transactions – in this case, U.S. Treasury repurchase agreements – in contrast to the unsecured interbank loans that support legacy benchmarks such as Libor.
However, while SOFR may indeed measure the cost of lending and borrowing in a more real-world fashion, those realities are not without complications.
Consider that in December, SOFR jumped from 2.46% the prior day to a peak of 3.00% on Dec. 31 – a wild swing that set a new record for the benchmark. The reason was that Treasury repurchase agreements typically see volatility around the close of every month, and are even more prone to big moves at the end of a quarter or the end of the year.
Libor clearly caused problems during the financial crisis because it was tied to unsecured loans and self-reported rates that obscured the real market risks. However, the big move for SOFR at the end of 2018 shows that basing newer alternative rates in the real world comes with its own challenges.
Making Overnight Rates Forward-Looking
A reliance on real-world transactions gives the new reference rates a much more solid foundation than Libor, but it also means that the rates are backward-looking.
That creates challenges for the current universe of legacy products tied to existing benchmarks. For instance, Libor is published in seven forward-looking tenors that range in duration from one day to 12 months.
There are currently efforts to use futures contracts on these new benchmarks to help derive forward-looking term rates. For instance, in April the Federal Reserve published a note on just such an effort for SOFR, expressing optimism that steadily growing use of futures for the relatively new benchmark bodes well for this kind of strategy. Similarly, a working group in Europe recently published its recommendations on the transition path from Eonia to €STR, including a forward-looking term structure methodology based on overnight index swap quotes.
It remains to be seen, however, whether there will be sufficient long-term liquidity in the new derivatives based on these risk-free rates to provide the foundations for the full array of forward-looking term rates that the market will require.
Absence of History in Newer Rates
When it comes to building confidence in new reference rates, it helps to have a deep pool of extant data to draw from. However, there are big differences in the publication history of each rate.
For instance, Sonia debuted back in 1997 and has a fairly deep history, and LCH first began clearing Sonia swaps roughly a decade ago. Additionally, there are publications of Saron data back to 1999.
By contrast, the New York Fed only began publishing SOFR rates in April 2018, and SOFR futures contracts began trading on CME and ICE less than a year ago. As for €STR, the ECB only recently began pre-publishing data based on its methodology in anticipation of a formal launch in 2019.
“There’s actually a large OTC market that’s already established in Sonia and that’s helping with the adoption of the U.K. products,” Rhodes said. “But in other currencies we’re building a market from scratch in a way, since there isn’t a natural swap market that has been established.”
That doesn’t prohibit new benchmarks from succeeding, of course. In April, on the one-year anniversary of SOFR’s publication, the New York Fed and the ARRC published a year-in-review document that pointed to 130 market participants using SOFR-linked products across both cash and derivatives markets, with an average daily notional value of more than $97 billion and total outstanding open interest of $468 billion.
However, other benchmarks like €STR are much farther behind in building out these markets in terms of market usage and establishing liquidity in related products. And even for SOFR, where the brief history we have is encouraging, the future is never a guarantee – and there remains much to be done in these markets when they are compared with legacy rates and their related products.
Legacy Contract Revaluation
Beyond future issuance and derivatives trading trends, it is a hard reality that legacy contracts will need a new reference rate if the underpinning benchmarks like Libor do indeed fade into the background.
That means these contracts will ultimately have to be revalued as part of the transition to new risk-free rates.
Some fear it will be a daunting task to convince borrowers that a new benchmark is fair if spreads increase materially – say, from Libor plus 2 basis points to SOFR plus 2.5 basis points instead – and thus banks will feel pressured to sacrifice spreads in any transaction repricing lest they damage relationships with borrowers.
Those real costs of any revaluations, coming on top of material transition costs as part of the broader move away from Libor, are not something to be simply overlooked.
There are also practical challenges with repapering existing contracts that should not be overlooked.
In the words of Andrew Bailey, chief executive of the FCA, an orderly transition to new reference rates “depends on the preparations that users of Libor make in either switching contracts from the current basis for Libor or in ensuring that their contracts have robust fallbacks in place that allow for a smooth transition if current Libor did cease publication.”
So while the ARRC recently published recommended contractual fallback language for U.S. dollar denominated floating rate notes and syndicated loans that reference Libor, those recommended provisions must in fact be inserted or amended to existing contracts to be effective.
Given all these uncertainties between the old world and the new, it’s incredibly important for certain products and individual securities to have adequate fallback provisions if and when Libor ceases to exist in the coming years.
After all, if the valuation of a product is tied to the last printed quote for Libor and that rate is non-existent, these contracts risk becoming worthless without an appropriate and legally binding alternative. While policymakers have been flexible on the future outlook of Libor, it is risky to assume the benchmark will exist forever.
In 2018, ISDA held a consultation on the various technical issues related to new benchmark fallbacks for derivatives contracts currently referencing interbank offered rates like Libor. According to a report on the effort published in December, “the overwhelming majority of respondents preferred the ‘compounded setting in arrears rate’ for the adjusted risk-free rate (RFR), and a significant majority across different types of market participants preferred the ‘historical mean/median approach’ for the spread adjustment.”
However, there is much work still to be done, bother large and small, before regulators and market participants agree on the precise formula for calculating the spread adjustment and the compounded setting in arrears rates.
Challenges in Discounting
There are also challenges in regards to collateral discounting at clearinghouses as markets move away from legacy rates.
For instance, LCH is currently in the act of transitioning discounting and price alignment interest (PAI) from Fed Funds to SOFR for the U.S. dollar interest rate swaps outstanding at the clearinghouse. The clearinghouse held a consultation in 2018 to plot a “goldilocks timeline” for the transition, said Philip Whitehurst, executive director for product management at LCH.
“It has to be long enough to develop a plan and prepare but not too far down the road since we don’t have an unlimited amount of time” before legacy rates like Libor are scheduled to fade away, he said.
After consulting with market participants, LCH plans to make the switch in the “second half of 2020,” Whitehurst said, and to do so in one single step rather than incrementally.
The clearinghouse is working hard to communicate a clear plan and minimize disruption from this move. But in addition to the delicate timing, there are also important adjustments that must be determined as this change in discounting methodology will result in a different forward-looking risk sensitivity as well as a change in current valuations.
LCH continues to gather feedback and is hard at work at finding the best solution, Whitehurst said, but there will have to be “tolerances with a rounding element to the equation.”
“In theory you can come up with a scheme that is fully neutralizing, and we are trying as hard as we can to get as close as we can to get to a genuinely zero P&L risk experience. But in practice, you can’t quite make everybody flat to the cent.”
What’s Next?
Though the move to replace Libor and other similar rates is undeniably a massive task, there has been significant headway made by regulators and the global financial community in these efforts over the last few years.
“A few years ago, people were saying, ‘I’d really rather not face this problem.’ But now people are recognizing that the problems with staying on a vulnerable benchmark is much bigger than the challenge of moving,” said Whitehurst of LCH. “If you asked me a year ago how I felt about the transition, I would have said I was worried. But I’m very comforted by benchmark related events in the industry. If you track how much more positive responses are to questions like are you prepared, do you have a budget, is there a senior manager responsible and board level approval on a plan, people are much better organized.”
Still, Whitehurst and others are quick to point out that their optimism is focused on derivatives markets where they work and have influence. In some jurisdictions, cash markets still have a way to go – as evidenced by the U.K.’s Financial Conduct Authority issuing a “Dear CEO” letter in 2018 that required executives to submit a board-approved summary from relevant firms regarding “key risks relating to Libor discontinuation and details of actions you plan to take to mitigate those risks.”
But the optimistic view is that derivatives markets have done their part, and the rest of the financial system will live up to its good example.
In the U.S., the ARRC’s previously published transition plan is ahead of schedule as clearinghouses already allow market participants a choice between clearing new or modified swap contracts using SOFR as the benchmark for price alignment interest and discounting in addition to the existing PAI/discounting environment using the effective Fed Funds rate.
And by this time next year, the market participants that make up the ARRC have set a goal that CCPs will no longer be accepting new swap contracts for clearing with the Fed Funds rate used for PAI and discounting, except for closing out or reducing outstanding risk in legacy contracts.
In the U.K., the Bank of England published a discussion paper in March that aims to support infrastructure service providers in the push for continued growth in Sonia referencing products, and to communicate best practices for referencing Sonia across bonds, loans and derivatives.
The ECB also published a plan in March that establishes new working groups and plans for consultations with market participants in the near future. The plan runs through 2020 that includes the transition path from Eonia to €STR and steps to establish a forward-looking term structure methodology for the reference rate.
Market participants and financial regulators are acting with a sense of urgency as the deadline for a potential end to Libor in 2021 looms large and the movement to reform global benchmark rates continues to gather momentum.
However, ISDA published its Interest Rate Benchmarks Review in April to analyze trading volume in derivatives using SOFR, Sonia, Saron and TONA. It reported that transactions referencing alternative reference rates accounted for less than 3% of total interest rate derivatives based on notional value during the first quarter of 2019. That proves there is still much work left to be done.
The big question, then, is whether global financial markets are up to the task and make the best of the roughly two years left until the previously appointed 2021 deadline to move away from Libor.
