The Japan Securities Clearing Corporation (JSCC) will launch a new set of Tokyo overnight average rate (Tonar) swaps for clearing this month, to aid the swaps market’s transition away from the yen Libor benchmark. But some market participants are sceptical the move will produce enough extra liquidity.
In December 2016, Japan’s central bank-led working group chose Tonar as the official alternative risk-free rate (RFR) to replace yen Libor in yen-denominated financial contracts.
Liquidity in overnight indexed swaps linked to the Tonar rate has been poor, though. In an attempt to boost volumes, JSCC will start clearing Tonar swaps with one-month, three-month and six-month coupon payments from March 26, according to a source close to the clearing house. These will be in addition to the Tonar swaps with a yearly coupon payment currently cleared by the central counterparty (CCP).
“Since Tonar has been named as the yen risk-free rate, there has been a discussion in the industry on fostering greater overnight index swap [OIS] usage,” says the source. “Responding to the demands from clearing members, JSCC is planning to expand its eligible clearing products to cover OIS with different coupon payments to the currently available one-year payment.”
Tonar OIS swaps have traded significantly less than their peers in other currencies. According to swaps data compiled by Clarus FT, Tonar made up a total of 0.4% of all swaps traded in the yen market over the first half of 2017. In the US dollar market, its OIS rate – Fed Funds – comprised 61% of all swaps traded across the main clearing houses. In sterling and euro, OIS as a percentage of total swap volume across the clearing houses was 48.4% and 47.4%, respectively.
The Bank of Japan is said to have pushed for the changes to coupon payments at JSCC in the hope it will breathe life into the yen OIS market. Three-month coupon payments would, for example, bring the exchange of interest payments on yen OIS in line with the convention for cross-currency swaps.
However, some dealers say more than just new coupon payment frequencies will be required to boost liquidity and ensure a smooth transition from yen Libor to Tonar.
“The biggest obstacle is the liquidity of the OIS swap market,” says Tatsuya Imai, a senior rates trader at Mitsubishi UFJ Morgan Stanley Securities in Tokyo. “JSCC is trying to encourage more OIS trading, and the fact that we will be able to trade not only 12-month but also six-, three- and one-month means the usability of the OIS swap is improving. But compared to euro or dollar markets, liquidity in yen OIS is still poor – and a liquid market is the minimum requirement for a smooth transition.”
In the rest of the world we are seeing clients putting trades on to take Libor risk off their books and replace it with OIS, but we have had nothing like that in JapanThomas Reich, Citi
The issue stems from the Libor rigging scandals, after which the Financial Stability Board directed national regulators to examine ways for their respective swap markets to reduce their dependency on Libor for swap contracts. Central banks in the most traded currencies created working groups to figure out what a possible alternative RFR could be for their market.
In July last year, the UK Financial Conduct Authority – which oversees all Libor rates – sped that process up, announcing it would drop its powers to compel panel banks to submit quotes from the end of 2021. This meant it is now possible the various currency Libor rates could end at some point after that date.
However, choosing an RFR with little liquidity to act as a so-called fallback rate to Libor if it dies poses two major problems. First, the lack of liquidity may discourage early movers who may otherwise want to start trading swaps linked to Tonar before yen Libor disappears.
“In the rest of the world we are seeing clients putting trades on to take Libor risk off their books and replace it with OIS, but we have had nothing like that in Japan,” says Thomas Reich, head of G10 rates trading at Citi in Tokyo. “If anything, OIS trading is slightly more active here than it was a couple of years ago, but it’s still nowhere near what we see in Libor swaps.”
Second, it makes it tricky to calculate the basis between it and the yen Libor rate it would replace in legacy contracts – a crucial element in transitioning legacy contracts.
“I think [the changes at JSCC] will not change the situation dramatically. But a shift in Japanese monetary policies and a fluctuation in the short-term interest rate could be a tail wind for the OIS marketTaki Hidesada, MUFG
Yen Libor has a bank credit element to it, so is higher than Tonar. So if yen Libor ended, the fallback rate needs to be Tonar plus the basis between the rate and yen Libor, to ensure minimal value transfers.
However it will also be necessary to capture the basis between the forward term structures of the two rates. Swaps users fear this could be difficult to achieve in Japan, given the paucity of OIS trading, when compared to other advanced swaps markets such as US dollar and sterling.
Mitsubishi UFJ Morgan Stanley Securities estimates only $40 billion equivalent notional of yen OIS swaps was cleared at the JSCC in the second quarter of 2017. To build a sufficiently reliable forward curve for the refixing of legacy Libor contracts, says Taki Hidesada, a rates strategist at MUFG in Tokyo, Tonar swap volumes need to reach an equivalent of $1 trillion to $2 trillion notional per annum.
He doesn’t believe the new coupon payment frequencies at JSCC will be enough on their own to bring the market close to this threshold – although a change in Japan’s interest rate environment might help.
In the current low rates-volatility environment, Tonar rarely moves, so market participants see few trading opportunities in swaps linked to the rate. But as the Bank of Japan cuts back its bond-buying programme, this might spur more interest.
“I think [the changes at JSCC] will not change the situation dramatically,” says Taki. “But a shift in Japanese monetary policies and a fluctuation in the short-term interest rate could be a tail wind for the OIS market.”
I have had many discussions with domestic financial institutions, and most of them mentioned one of the biggest problems of OIS fixing is the set-in-arrears schemeTaki Hidesada, MUFG
Other incentives might be required to encourage wider adoption in the yen market. One of the drawbacks of OIS, he says, is the convention for OIS swaps currently traded in Japan, the US and Europe to be set-in-arrears – in other words, with the floating leg determined at the end of the payment period. This makes OIS poorly suited to use for hedging floating rate bonds and loans for which the rate is set-in-advance. This is also the current convention used by yen Libor.
Furthermore, some financial institutions may decide the cost of developing the system infrastructure to move to in-arrears benchmarks is prohibitive.
He suggests taking a so-called semi-multiple rate approach to mitigate the problem. This would see the OIS market split into two groups, with one side fixing the OIS floating leg in advance, and the other – following the current convention – fixing in arrears.
Clearing houses would enable two-way hedging between the two groups. Those market participants who choose to invest in the infrastructure to handle set-in-arrears OIS would receive a prescribed spread on six-month OIS from swaps users using set-in-advance OIS.
This would provide an incentive for dealers to invest in the system infrastructure required to advance the transition to an OIS market based on the set-in-arrears payment convention. But it would also allow notes and loans to continue to be priced in arrears.
“I have had many discussions with domestic financial institutions, and most of them mentioned one of the biggest problems of OIS fixing is the set-in-arrears scheme,” says Taki. “It is not a critical problem in the derivatives market, [but] it will be difficult to explain it to corporate loan borrowers or individual mortgage borrowers. So if a Libor-linked bond or loan is transferred to an OIS-linked bond or loan that is set-in-arrears, institutions will need to reconstruct their accounting and booking systems.”
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