Japan weighs benchmark options as sun sets on Libor

Dominance of risk-free rates in local swaps markets post-Libor is no foregone conclusion, dealers say

Japan’s yen interest rate swap market is the third largest in the world after the US dollar and euro, with nearly $40 trillion of outstanding contracts, according to the latest Bank for International Settlements data.

Yet when the country’s prevailing Libor benchmark ceases, as expected, at the end of next year, there is no obvious single replacement rate.

Three possible alternatives are waiting in the wings: a backwards-looking compounded version of the regulator-approved risk-free rate, the Tokyo overnight average rate, or Tonar; a forward-looking term version of that rate known as Torf; and Tibor, a local panel-set rate that closely resembles the outgoing yen Libor.

Dealers believe there’s a chance the market will be divided between all three rates, which would raise questions for risk management, access to hedging and overall trading costs.

“It would be difficult to develop an efficient and liquid market if there are three benchmarks,” says a quantitative analyst at a Japanese bank in Tokyo. “That would be challenging.”

A worryingly large number of Japanese firms, dealers say – especially smaller banking groups and buy-side firms – are not yet ready to use compounded versions of overnight rates, which are incompatible with current banking systems and practices. This may hold back adoption of the overnight rate, some say.

“In that scenario, we may never see a liquid Tonar swap market develop,” says the head of a quant team at a second Japanese bank.

The problems are not limited to Japan. Hong Kong is another jurisdiction that is planning to operate a so-called multi-rate benchmark regime. The local regulator has no plans to discontinue its own-label brand of Libor, known as Hibor. But authorities are mindful of the move to risk-free rates in other global markets and are keen to encourage greater use of the Hong Kong overnight index average, or Honia (see box: Slow boat to Hong Kong).

Others feel the multi-rate approach has its drawbacks.

“If you have a choice of rates then it is difficult to move everyone together,” says Andrew Ng, head of treasury at DBS in Singapore. “So I think to have one overnight rate is the best way to go.”

For now Singapore stands alone as the one jurisdiction in Asia to fully commit to a single overnight risk-free rate. Earlier this year, local industry groups proposed phasing out the Singapore interbank offered rate. Three years from now, traders in the Singapore dollar rates market will have only one rate with which to benchmark swaps or lending transactions: the overnight risk-free rate.

Ready or not

Ever since July 2017 when the then head of the UK’s Financial Conduct Authority, Andrew Bailey, delivered a speech that raised doubts over the future sustainability of Libor, banks across Asia have been busy preparing for the benchmark’s likely demise. But progress has been uneven.

Larger financial institutions in Japan – such as the three megabanks – are already comfortable with the use of compounded-in-arrears overnight rates, either for derivatives or cash products. Compounding the benchmark in this way enables users to mimic the term nature of Ibor rates, which exist in tenors such as three months or one year.

As reported in November by Japanese finance magazine Kinzai, a large Japanese trading company is understood to have recently entered into a Tonar swap with one megabank and a Tonar loan agreement with another bank.

However, the lack of readiness among the country’s insurance companies and lower-tier regional banks to use compounded Tonar in place of yen Libor for interest rate swaps is a cause for alarm, says the quantitative analyst at the Japanese bank.

Using compounded-in-arrears overnight rates has long been the standard method for settling payment obligations for overnight index swap (OIS) transactions. However, the Japanese yen OIS market is traditionally dominated by overseas financial institutions and the largest domestic banks, meaning many of the country’s smaller institutions lack familiarity with the convention.

With publication of yen Libor likely ceasing at the end of next year as recently proposed by its administrator, Ice Benchmark Administration, it would appear that these institutions are cutting it fine, says the analyst.

“In my understanding, tier three banks will not be ready [to trade OIS] until the middle of next year,” the analyst says. “That’s a concern because it is too late. Probably they will think that they are ready and then they will find out that they are actually not ready.”

There is some evidence, nevertheless, to suggest the transition of the derivatives market to Tonar is beginning to gather steam. In the year to November, the cleared notional of yen OIS linked to Tonar at the Japan Securities Clearing Corporation stood at ¥33.9 trillion ($325 billion), up from the ¥23 trillion of cleared notional in full-year 2019.

If the liquidity of the Tibor-based swap increases to a meaningful level before liquidity picks up in Tonar then people might just start to trade Tibor swaps instead of dealing with the new risk-free rate

Head of a quant team at a Japanese bank

The volume of swaps referencing yen Libor at the clearing house remains much larger, however, indicating that the transition to OIS still has some way to go. In the year to November, the cleared notional of yen Libor swaps at JSCC was ¥553 trillion.

After publication of yen Libor ceases, the general expectation is that the bulk of the derivatives market will shift to Tonar. The benchmark was selected by a cross-industry working group as the preferred risk-free rate in December 2016, and swaps referencing the rate are cleared by both of Japan’s clearing houses, LCH and JSCC.

The benchmark is also the fallback rate for yen Libor contracts, meaning that legacy contracts referencing the outgoing Libor will automatically transition to Tonar upon activation of the Isda fallback protocol. Maintaining consistency with the approach taken for other Libor fallbacks, such as SOFR for US dollar contracts and Sonia for sterling contracts, also provides an incentive to use a compounded-in-arrears version of Tonar for new derivatives trades.

“I think it is the case that people are starting to prepare their systems and accounting and internal risk management to trade Tonar,” says the head of the quant team at the second Japanese bank. “My personal view is that [a move to Tonar] will only happen just before the end of Libor, so around this time next year.”

Liquidity challenges

Dealers say the eventual dominance of Tonar in the Japanese yen swaps market should not be considered a foregone conclusion, however.

In the past three years, liquidity in swaps linked to Japanese yen Tibor (D-Tibor) – a benchmark based on unsecured interbank rates quoted by a panel of Tokyo-based banks – has been steadily increasing. In 2018, for example, the cleared notional of D-Tibor swaps at JSCC was roughly ¥1.7 trillion. By November this year, that figure had surged almost fivefold to ¥8.3 trillion.

Liquidity in Japanese yen Tibor could be further boosted if the offshore Euroyen Tibor (Z-Tibor) is discontinued or integrated into D-Tibor at some point in the years ahead, as the Japanese Bankers Association Tibor Administration has suggested could happen. As of November, the notional of Z-Tibor swaps at JSCC was ¥9.1 trillion. If trading on Z-Tibor merged into D-Tibor, volumes on the domestic rate could more than double.

Assuming liquidity in D-Tibor swaps continues to grow over the coming 12 months, at the point of yen Libor’s cessation D-Tibor could look like a sufficiently liquid alternative to Tonar for any remaining market participants that are unprepared to use compounded-in-arrears overnight rates, says the quant head at the second Japanese bank.

“That could be a risk,” he says. “At least for lending markets, most [Japanese] banks are already used to providing Tibor transactions, and that creates a hedging demand for Tibor-based swaps. If the liquidity of the Tibor-based swap increases to a meaningful level before liquidity picks up in Tonar then people might just start to trade Tibor swaps instead of dealing with the new risk-free rate.”

The quantitative analyst at the first Japanese bank is doubtful this will happen. A lack of volatility in Tibor makes it unsuitable as a benchmark for swaps, he suggests. Furthermore, the benchmark is not currently cleared at LCH, which would limit uptake among non-Japanese institutions unable to clear at JSCC.

However, the analyst says a more plausible outcome would be one in which the Tokyo term risk-free rate, Torf, a term version of Tonar being developed by Quick Corp, is adopted in some of the unprepared parts of the yen swaps market instead of Tonar.

“In the derivatives space – for the purpose of reflecting a short rate – Tonar should be the first choice, Tibor is simply useless, and many people still seem to be waiting for Torf,” the analyst says.

But if lower tier banks use Tibor for swaps, counterparties may struggle to find offsetting trades in an interdealer market that has by and large moved to risk-free rates, says the quant team head.

“For interdealer markets they will have no offsetting position, which means more capital charges for market-makers,” he says. “That should split market liquidity and the cost of hedging the basis risks may be passed on to the buy side or other banks.”

Basis risks could even emerge in a situation where parts of the market are using compounded-in-arrears Tonar and other market participants are using Torf, says the analyst.

Such basis risks can arise in stressed markets, such as the conditions seen in March when the economic fallout from the Covid-19 pandemic began to rattle financial markets. On March 10, the difference between compounded Tonar and Torf was 12 basis points.

“As [the FCA’s] Edwin Schooling-Latter has been warning, there will be some basis risks between overnight and term rate,” says the analyst. “When liquidity is small the term rate could show some spikes. So the basis risk between Tonar and Torf will need to be managed going forward and the hedging cost of that will not be free.”

Slow boat to Hong Kong

In Hong Kong, adoption of the local risk-free rate, Honia, is moving at a snail’s pace, which dealers attribute mainly to a lack of readiness among market participants to make the change.

The Hong Kong Exchange’s OTC Clear service does not publish volume data for swaps linked to specific benchmarks such as Honia – which the clearing house began clearing in July – but dealers say the Honia swap market remains very illiquid.

Some suggest the regulator’s decision to retain Hibor alongside the risk-free rate may mean market participants have less urgency to switch benchmarks.

“Hong Kong is taking a two curve approach so, unlike Libor, there will be no hard demise for Hibor,” says William Shek, head of credit and rates at HSBC in Hong Kong.

As in Japan, a considerable portion of the market continues to prefer to use Hibor because it is a forward-looking term rate with tenors up to 12 months.

“In Hong Kong, you have Hibor that has a term structure – so why would you use Honia?” asks a head of rates trading at an Australian bank.

Honia has been incorporated as the fallback for Isda swap contracts linked to Hibor. But with Hibor not under threat of cessation, the fallback is unlikely to be triggered in the foreseeable future.

Instead, hopes of an organic shift away from Hibor largely rest on the gravitational pull of the other major rates markets switching from Libor to risk-free rates.

As is the case in most Asian markets, banks and corporates in Hong Kong are heavily reliant on the US dollar market to meet general funding needs.

Between January 2019 and July 2020, for example, banks and companies in Hong Kong have been responsible for roughly $5 billion of US dollar floating rate note issuance, according to Bloomberg data.

After Libor cessation, SOFR will become the benchmark used on the US dollar side of HK dollar/US dollar cross-currency swaps, creating an incentive to use Honia on the HK dollar leg, HSBC’s Shek says.

The first HK dollar/US dollar cross-currency swaps linked to Honia and SOFR were traded by HSBC, Goldman Sachs and Standard Chartered in October.

But low levels of liquidity in Honia swaps could mean that these cross-currency swaps will at first continue to reference Hibor on the HK dollar leg even after the US dollar leg moves to SOFR.

“You will see Hibor versus SOFR first,” Shek says. “I don’t think Honia will be able to catch up with the liquidity of the Hibor market just yet, so I think initially people will use SOFR for the US dollar side and then Hibor on the HK dollar side.”

In both markets, these outcomes could have significant risk management implications for dealers. A cross-currency swap with a risk-free rate on one leg and an unsecured rate like Hibor on the other side would result in additional volatility in the position relative to a cross-currency swap that uses a risk-free rate on both sides of the transaction.

The future cessation of US dollar Libor could have a further impact on liquidity in the Honia swap market. Once non-financial corporations become familiar with SOFR as a benchmark for US dollar funding, some might eventually start exploring the use of Honia as a benchmark for HK dollar financing too. The issuance of Honia-linked notes would then create a hedging demand that should drive comparable growth in the market for Honia-linked swaps, Shek says.

Editing by Alex Krohn