By Waqas Samad, CEO, Benchmarks
In a previous blog from July, I highlighted the scale of the task at hand to shift the market from its dependency on LIBOR. The regulatory authorities across the globe have encouraged the market to develop solutions to this problem and, judging by the transactions in the swaps and futures markets and the nascent activity in the bond markets, it seems that the market in the UK is certainly taking up the charge. Overnight derivatives based on a benchmark rate known as Sterling Overnight Index Average, or SONIA—which has replaced LIBOR—have started trading, and some bonds linked to the new SONIA RFR rates have been issued, too. As we can see from the table below, the market has grown to approximately £30B in notional on the new futures contracts linked to SONIA RFR.
Source: Curve Global/CME/ICE. Data as of October 19, 2018.
Of course, that’s still a drop in the ocean compared to the legacy books using sterling LIBOR; short-sterling open interest is at almost £1.7T versus SONIA’s £30B.
So the market is grinding into life, and further developments will follow in time.
But of the approximately $200T in outstanding instruments linked to LIBOR, about 10% is in those that the BoE’s Working Group consultation highlighted as needing a term rate solution, rather than an overnight RFR. Moreover, the FSB in July highlighted that while the overnight RFR based market would be where derivatives would be focused, there was likely to be a need for Term RFRs. This is especially the case in cash markets where those cash markets require some “forward expectation of overnight RFRs over a designated period or term.”
That sounds familiar... so how to build those solutions while avoiding the drawbacks of term rate benchmarks that have been learned in the last 10 years? The first important point is to build the term rates using transactions and actionable quotes on overnight markets wherever possible to ensure as much transparency as possible. The futures markets for SONIA are a viable source of data, but for swaps it may be that an order book approach could be beneficial to avoid the pitfalls of a system based on dealer quotes. That doesn’t exist right now, but is something to explore.
The second is to root the methodology in as broad a set of data as possible; the best term rate will be calculated using swaps and futures from as many of the markets and venues that are trading as possible, so that it represents the market view taking into account all the liquidity pools available.
And last, but certainly not least, create a robust and rigorous governance process to ensure there is oversight over the methodology and that it can evolve as these newer markets that underpin it evolve. We are at the beginning of the journey here, and the market dynamics are sure to change. The term rate therefore needs to evolve, but in a manner that is controlled and orderly, with input that represents the various types of market participant. For that, we believe that the kind of oversight exercised by a benchmark administrator provides the most robust framework.
Assuming a solution to the term rate problem can be appropriately designed and implemented, what’s next? The transition and fallback approach for the extant book of derivatives contracts is being addressed by the International Swaps and Derivatives Association (ISDA), but what about those markets that are best served by a term rate? The same transition and fallback issues need to be thought through for loans, bonds, securitizations and the like.
Deep dialogue and close cooperation will be required between the issuers of those cash instruments, the investors, the dealers, the regulators and the providers of infrastructure and tools that service them. It’s clear that the direction of travel for hedging of derivatives is to build liquidity in the overnight markets. The question will be whether demand from those cash markets will drive the development of credible alternative term rates and whether there will be a clear and orderly transition path to adoption.
We will continue to watch developments carefully.
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