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.
© 2018 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE Global Debt Capital Markets Inc. and FTSE Global Debt Capital Markets Limited (together, “FTSE GDCM”), (4) MTSNext Limited (“MTSNext”), (5) Mergent, Inc. (“Mergent”), (6) FTSE Fixed Income LLC (“FTSE FI”) and (7) The Yield Book Inc (“YB”). All rights reserved.
FTSE Russell® is a trading name of FTSE, Russell, FTSE GDCM, MTS Next Limited, Mergent, FTSE FI and YB. “FTSE®”, “Russell®”, “FTSE Russell®”, “MTS®”, “FTSE4Good®”, “ICB®”, “Mergent®”, “WorldBIG®”, “USBIG®”, “EuroBIG®”, “AusBIG®”, “The Yield Book®”, and all other trademarks and service marks used herein (whether registered or unregistered) are trademarks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, MTSNext, FTSE GDCM, Mergent, FTSE FI or YB. FTSE International Limited is authorised and regulated by the Financial Conduct Authority as a benchmark administrator.
All information is provided for information purposes only. All information and data contained in this publication is obtained by the LSE Group, from sources believed by it to be accurate and reliable. Because of the possibility of human and mechanical error as well as other factors, however, such information and data is provided "as is" without warranty of any kind. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the accuracy, timeliness, completeness, merchantability of any information or of results to be obtained from the use of the FTSE Russell Indexes or the fitness or suitability of the FTSE Russell Indexes for any particular purpose to which they might be put. Any representation of historical data accessible through FTSE Russell Indexes is provided for information purposes only and is not a reliable indicator of future performance.
No responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for (a) any loss or damage in whole or in part caused by, resulting from, or relating to any error (negligent or otherwise) or other circumstance involved in procuring, collecting, compiling, interpreting, analysing, editing, transcribing, transmitting, communicating or delivering any such information or data or from use of this document or links to this document or (b) any direct, indirect, special, consequential or incidental damages whatsoever, even if any member of the LSE Group is advised in advance of the possibility of such damages, resulting from the use of, or inability to use, such information.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing contained in this document or accessible through FTSE Russell Indexes, including statistical data and industry reports, should be taken as constituting financial or investment advice or a financial promotion.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group data requires a licence from FTSE, Russell, FTSE GDCM, MTSNext, Mergent, FTSE FI, YB and/or their respective licensors.