The Bank of England’s Working Group on Sterling Risk Free Reference Rates, which is tasked with leading the transition away from Libor to term Sonia (sterling overnight index average) rates (TSRRs), has launched a consultation process to help drive the evolution, which is intended to be complete by the end of 2021.
The work is part of a global effort to shift interest rate benchmarks away from the scandal-ridden mechanisms such as Libor, Euribor and Tibor. Last week ISDA launched a consultation on fallbacks for the new benchmarkand the Financial Stability Board reinforced its support for the move by stressing in a report its support for the transition of most derivatives to robust overnight risk-free rates, noting this is important to ensuring financial stability. TheFSB also said it supports efforts to develop robust RFR-derived term rates where these can facilitate Libor transition.
The primary obstacle to the transition remains the absence of deep liquidity in futures and derivatives that reference term risk-free rates thanks mainly to the absence of a forward curve for these products.
In its introduction to the latest consultation, the BoE Working Group notes that Sonia is an overnight rate, whilst Libor is most commonly referenced in three and six-month tenors. “Derivatives markets participants are ‘fluent’ in the direct use of overnight rates, where payments are calculated based on an average of realised daily rates, but an important subset of end users in loan and debt capital markets report that term rates are essential for their business needs,” the groups states. “We believe that term rates can play an important role in facilitating transition to Sonia. They complement ongoing efforts to encourage the direct use of overnight rates in financial contracts.
“In this context we welcome the European Investment Bank’s efforts to establish Sonia as a new market standard in sterling FRN markets,” it adds. “The majority of Working Group members believe that overnight rates offer compelling benefits in many applications, and that most users will, over time, adapt to referencing Sonia directly in their financial contracts.”
The Working Group points out that while its consultation has been launched at the same time as ISDA’s, the two outreach efforts address different aspects of benchmark reform. “The ISDA consultation is focused on preventing derivatives market disruption in the event a key IBOR is discontinued,” the paper says. “Our consultation focuses on how a TSRR can be constructed in order to facilitate sterling Libor transition in markets where term rates better suit users’ needs.
The Working Group argues that in a “significant majority of cases” where sterling Libor is used, an overnight rate like Sonia will meet users’ needs. It does accept, however, that it has identified operational challenges which could inhibit the use of an overnight rate by users in loan and debt capital markets. In addition, it says that an important subset of end users in these markets report that term benchmarks serve genuine risk management needs such as cash flow forecasting or managing interest rate risk. “The development of TSRRs for use in these markets can therefore play an important role in facilitating transition to Sonia,” the paper states.
It adds, though, that outreach did not identify significant demand for TSRRs from active participants in cleared OTC and exchange-traded derivatives markets, where participants note that there is already an active OIS market which references Sonia directly, and interest rate futures which directly reference Sonia have recently been launched. “However, some users will require suitable hedges for financial instruments such as loans, securitisations and floating rate notes which may reference TSRRs in future – so some use of TSRRs in derivative markets is likely,” the Working Group says, adding, “Whilst TSRRs may prove sufficiently robust for selected applications, supervisory authorities – including the Financial Stability Board – and some market participants have expressed significant reservations regarding their suitability for widespread use in the derivatives markets which currently reference Libor.”
The paper highlights the challenge involved in using Sonia derivatives markets to help set TSSRs, noting that while liquidity in the short dated tenors is sufficient to support the new benchmark, futures volume and open interest remain “relatively low”. It does not, however, that volumes should increase as the markets for these new products mature.
As there are few spot-starting OIS trades in specific one, three, six and 12-month tenors, though, executed transaction data cannot be wholly relied upon to produce a robust benchmark, the paper adds. A broader set of transaction data, including forward-starting OIS trades – which make up around 80% of transactions – could be used to produce TSRRs but with the application of a centralised yield curve model, it suggests.
Another potential source of data are firm, executable quotes, which provide a high degree of transparency and a strong link to transaction data, but with the benefit of ongoing availability even where transaction volumes are low. Quotes can be obtained for spot-starting OIS in the required tenors without the need for a centralised yield curve model, the paper says, instead, the average of the quotes reflect a market consensus yield curve which is supported by liquidity and arbitrage in forward-starting OIS trades.
The paper does also touch upon using indicative quote surveys to produce the rates, however it observes this data source is less grounded in transactions and is more challenging to verify. It also closely reflects the submission process for Libor, but the Working Group says it may be useful for producing ‘prototype’ TSRRs.
Overall the paper argues that firm quotes for Sonia OIS in one, three, six and 12-month tenors are “likely to offer the most feasible and robust data sources for TSRRs in the near-term”.
It adds that the problem remains, however, that these data inputs are not readily available. “Market transparency is currently limited – the most reliable quotes may only be available under subscription, and even these may be indicative rather than firm,” the paper states. “Therefore, production of a TSRR using firm quotes requires further development in the trading of OIS: by moving from a predominantly voice OTC market, to one more frequently traded on regulated electronic platforms which will be a more transparent and verifiable data source.
“Notwithstanding this, data sources and methodologies should evolve with changes in market structure,” it adds. “For example, as liquidity develops in Sonia futures these may provide reliable pricing inputs from a regulated market with a high level of transparency and a broad participant base.”