Singapore’s key benchmark for interest rate swaps could be replaced by an alternative version that applies a spread adjustment over the US dollar risk-free rate to preserve the present value of contracts should Libor cease to exist after 2021, people familiar with the matter say.
A revised Singapore Swap Offer Rate that uses the secured overnight funding rate (SOFR) in place of US dollar Libor – a current calculation input – is being considered by a group led by the Singapore Foreign Exchange Market Committee (SFEMC), the people say.
The SOR reflects the cost of borrowing US dollars before swapping the amount back into the domestic currency at the same maturity, making it partly a function of US dollar Libor. It is the most frequently used reference rate for the floating leg of Singapore dollar-denominated swap trades.
To compensate for the difference between Libor and SOFR, which is based on repo financing and is on average 30 basis points lower than Libor, a spread adjustment similar to the International Swaps and Derivatives Association’s proposed Libor fallback methodology could be inserted into the SOR methodology, one source says.
The path adopted by the SOR administrator, the Association of Banks in Singapore, will be watched keenly by local derivatives users. The Singapore dollar accounts for 17% of interest rate derivatives trading in the region. The solution could also be of interest to two other interest rate benchmarks in Asia-Pacific – the Philippine Interbank Reference Rate and the Thai Baht Interest Rate Fixing, which also rely on a similar swap mechanism to arrive at the rate.
“The transition should be as seamless as possible, so the key question is how to replace Libor in the [SOR] equation,” says Eugene Leow, an interest rates strategist at Singapore’s largest lender, DBS Bank. “They are going to have to replace Libor with SOFR plus a spread in order to transform SOFR from an overnight rate into a term rate and then to adjust for the credit spread, because SOFR is considered near risk-free.”
They are going to have to replace Libor with SOFR plus a spreadEugene Leow, DBS Bank
Leow says an adjusted SOFR would be one feasible solution to prevent changes to the present value of SOR contracts if the risk-free rate replaces Libor after 2021, when panel banks are no longer compelled to submit to the rate.
The adjusted SOFR option is among several being considered by the SFEMC, a source familiar with the discussion says. The administrator is said to be delaying the finalisation of the new methodology in order to observe developments in the US rates market, such as the creation of a forward-looking term version of SOFR.
Discussions around how any such changes to the benchmark would need to be reflected in trade documentation are also ongoing. Possible amendments to the 2006 Isda Definitions for new interest rate swaps and a protocol to migrate outstanding trades have both been debated.
Kai Loon Loh, a derivatives lawyer at Ashurst ADTLaw in Singapore, says there is an expectation that reforming the SOR benchmark will inevitably have contractual implications.
“I think most people appreciate that there may be a need to repaper,” he says.
According to a 2017 Isda analysis of data from the Bank for International Settlements, the Singapore dollar accounted for 17% of total turnover of interest rate derivatives in the Asia-Pacific region, the second most-traded currency behind the Australian dollar.
Sources say the SFEMC group is likely to be waiting on developments in the US rates market before making a conclusive decision on how to replace Libor in the SOR methodology.
“I think it is still early days,” says Leow. “We should get more clarity in the next year or two.”
Uncertainty surrounding the future availability of a forward-looking SOFR term structure is one reason the group is believed to be biding its time. SOFR measures the cost for banks of borrowing cash overnight in the US Treasury repo market. To calculate SOR at its one-month, three-month and six-month tenors, it is necessary to determine the US dollar cash flows for each tenor to be swapped into Singapore dollars at the beginning of the accrual period.
Referring to a ‘compounded setting in arrears rate’ – a backward looking measure – to replicate a term structure, as Isda has proposed for Libor fallbacks would, according to some, be an imperfect solution.
“With a forward-looking interest rate benchmark like US Libor, you know exactly the cash proceeds you are going to receive at six months or three months – and, therefore, the notional for the forex forward to translate back into the domestic currency,” says Robert Walton, manager for interest rate benchmarks at Refinitiv in London. “But if you’re using, say, SOFR compounded overnight, then you would only know the amount you are going to get in arrears.”
The Alternative Reference Rates Committee, the group of market participants that is overseeing the US market’s transition to risk-free rates, is working on establishing a forward-looking term SOFR rate, which is expected to begin publishing by the end of 2021.
The Federal Reserve Bank of New York is to begin publishing a series of backward-looking secured overnight financing rates in the first half of 2020.
If a matching term structure for SOFR is established in time, sources say the SFEMC group could dodge the tricky question of how to replicate Libor’s various tenors in the SOR calculation. An additional spread accounting for the bank credit component present in Libor is all that would be required.
Other observers speculate that the SFEMC might be delaying its decision until there is more clarity on the future of Libor, as well as the development of more similar alternatives.
International regulators recently indicated that Libor could be kept alive after the point in 2021 when its contributor banks would otherwise have been free to abandon the benchmark. The extension was mooted specifically to help the market for cash products find an appropriate forward-looking replacement benchmark before publication of Libor ceases.
Ice Benchmark Administration, Libor’s administrator, is also exploring the viability of a new benchmark with similar characteristics to Libor called the US dollar bank yield index. The benchmark would be fully transaction based and would measure trades in commercial paper, certificates of deposit, interbank deposits and bonds of the banks with maturities out to one year.
A rates strategist at an international bank in Singapore hints that the SFEMC group could look to such a rate as another alternative benchmark for use in calculating SOR.
“SOFR is the frontrunner, but these things can change,” he says. “I understand IBA is now saying it will publish a Libor-like benchmark, for example.”
Editing by Helen Bartholomew