Evolution or extinction: Ice swap rate’s post-Libor quandary

Thin liquidity in SOFR swaps imperils reference rate for $40 trillion swaptions market

As Libor’s future hangs in the balance, so too does the fate of a lesser-known but widely used benchmark underpinning a gamut of financial instruments, including swaptions, rate-linked structured products and some floating rate debt.

The Ice swap rate – formerly IsdaFix – is a key measure of term swap rates. It represents the mid-price for the fixed leg of Ibor-referencing interest rate swaps and is published for maturities from 12 months to 30 years across sterling, euros and US dollars. Calculated using firm, executable prices from electronic venues, the rate relies on a liquid underlying swap market –  which may not be guaranteed as the swaps market transitions from Libor to risk-free rates (RFRs).

Now, the benchmark faces extinction if it is unable to adapt to RFR swaps, which currently trade only via request-for-quote protocols and with limited liquidity.

“There will need to be a transition of this benchmark to overnight rates. It’s something the industry is beginning to look at, but no decision has been made yet on its future,” says a fixed income trading head at one European dealer.

“We’re only just starting to look at how you might calculate a new swap rate, how that might be defined and all the derivatives that would reference it. It’s going to be very difficult and shows that benchmark reform is a much heavier lift than anyone estimated.”

It is yet another monumental task facing industry participants as they aim to move an estimated $400 trillion of financial products off Libor by the end of 2021, when banks will no longer be compelled to contribute to the discredited benchmark.

“This is like replacing all petrol cars with electric vehicles overnight. It’s a big ask, but I think the market is headed there in the long term,” says Stuart Giles, managing director for business development and strategy at Tradition – one of three venues whose central limit order book (Clob) prices feed into the swap rate.

It is understood that the benchmark’s administrator – Ice Benchmark Administration – discussed the issue with industry participants earlier this month. A spokesperson for IBA declined to comment.

There will need to be a transition of this benchmark to overnight rates

Fixed income trading head at a European dealer

Industry sources say users of the rate are being encouraged to express their views on its future direction as part of the wider Libor transition debate. Some, however, are calling on IBA to make the first move by declaring whether it can continue publishing the rate with some fallback input.  

“Once IBA makes that determination the industry will decide what else, if anything, is necessary,” says an industry lawyer familiar with the issue. “Right now, the ball is in IBA’s court to announce what it would do with regards to the swap rate, and once that occurs, other work will follow.”

So far, there is little industry consensus on how the rate should be adapted, or whether it is fit for purpose in a post-Libor world. While the International Swaps and Derivatives Association is busily readying fallback language for vanilla interest rate swaps, work to determine the fate of more complex products – and the infrastructure underpinning them – remains at a very early stage.

“Discussions around the future of the Ice swap rate are very preliminary, and there’s very little [happening] other than some banks and institutions using swaptions for hedging trying to figure out how it’s going to work for the options in their portfolio. The way swaptions are traded now is completely incompatible with an overnight rate,” says Subadra Rajappa, head of US rates strategy at Societe Generale.

The swap rate is used to calculate the exercise value of cash-settled swaptions – a $40 trillion notional market used primarily to hedge negative convexity risk associated with mortgages. It is also the reference for close-out payments on early terminations of interest rate swaps and a key input for constant maturity swaps, which underlie the majority of rates-based structured products such as range accruals. The benchmark’s uses extend to the cash market, where it appears as a reference for some floating rate bonds – including the new 10-year forward, 10-year-linked notes – as well as bank capital securities as they reset from fixed to floating format.

“It’s a very crucial rate. The discussion on its future needs to be taken up by everyone. You can’t just do the fallbacks for Libor, you need to deal with this rate at the same time,” says an industry source familiar with the rate methodology.  

No quick fix

An obvious solution would see IBA apply the current methodology to overnight index swaps (OIS) on Libor successor rates such as the UK’s sterling overnight index average rate (Sonia) or the secured overnight financing rate (SOFR) in the US. This would allow a new OIS version of the benchmark to co-exist alongside the old Libor version for an interim period. The Libor version could then be discontinued once swaps liquidity makes a full transition to RFRs.

In practice, it’s not so straightforward. Neither Sonia nor SOFR swaps are yet quoted on electronic Clobs – the only accepted inputs since a 2014 clean-up saw the submissions-based IsdaFix morph into the new-look transaction-based rate. Under the new methodology, IBA takes pricing snapshots of firm, executable prices from three multilateral trading venues: BGC Partners’ BGC Trader, Icap’s i-Swap and Tradition’s Trad-X.

As liquidity grows in the Sonia and SOFR derivatives markets, industry participants expect the instruments to transition to electronic order books. This would start with Sonia swaps, which are already liquid in shorter maturities. The pre-existing rate was already widely traded before being selected as the UK’s Libor successor, having been used as the discounting rate for sterling-denominated derivatives for a decade.

“Creating order books for Sonia is very simple and can be done very quickly,” says Tradition’s Giles. “Sonia is traditionally liquid to two years on the outrights but you can get a basis right out to 60 years. If you were going to do a trade at the longer end, it would be a basis trade at the moment, but we are seeing the duration extend. It’s all part of the transition and evolution process.”

Ideally, providers of data and prices in the order books will offer firm prices for an extended period to ensure a smooth transition. However, providing two sets of liquidity means double the potential risk for market-makers

Stuart Giles, Tradition

Other hurdles exist: for instance, most OIS is not spot-starting. The majority of Sonia swaps have forward start dates to align with meetings of the Bank of England’s monetary policy committee (MPC). This is relatively easy to overcome, according to Giles.

“If the MPC dates are trading, they’re not too far from one-month or three-month dates, so you can imply one from the other. Everyone with a pricing model could price you one-month, three-month and six-month,” he says.

The real difficulty lies in the period of transition. In order to publish both OIS and Libor rates concurrently, market-makers would need to make firm order book prices for both Libor and RFR swaps – at least for a period of time.

“Ideally, providers of data and prices in the order books will offer firm prices for an extended period to ensure a smooth transition. However, providing two sets of liquidity means double the potential risk for market-makers,” says Giles.

RFQ too?

While a Clob for Sonia swaps may not be too far from reach, the nascent market for SOFR swaps poses a bigger challenge. Just 69 swaps trades referencing the newly created rate with a notional value of $22.6 billion were registered on US trade repositories during the first quarter of 2019, according to data compiled by the Isda. A hotly anticipated ‘big bang’ switch to SOFR discounting for all US dollar-denominated swaps could trigger a liquidity windfall in the instruments. Such an event is under discussion for late 2020, meaning it could be 2021 before SOFR swaps take their first steps into electronic order books, where they could facilitate publication of a new swap rate.

With Libor on the chopping block after the end of 2021 and Clob trading still out of reach for RFRs, some market participants believe the swap rate methodology may have to adapt and align with current market practice. This could mean accepting price inputs from request-for-quote platforms such as Bloomberg and Tradeweb.

“The rate has to evolve and move to OIS but the question is how. One way is that the markets accommodate the current methodology and OIS are traded on Clobs. The other way is that the rate adapts and takes prices from where these products are traded and where liquidity really is. If that’s not a Clob, then so be it,” says a second source familiar with the rate methodology.  

In its former guise as IsdaFix, the rate was calculated via polling of contributor banks. The 2014 overhaul, which responded to benchmark guidelines issued by the International Organization of Securities Commissions, aimed to eliminate any element of “expert judgement” from the methodology and saw IBA take over from Isda as administrator.

At the time, a widespread shift from voice trading to exchange-like venues for global swaps activity was anticipated. In reality, final trading rules in US and European post-crisis regulations kept the door open for swap execution platforms and multilateral trading facilities to continue offering request-for-quote trading protocols, where the majority of swaps activity has remained.

I don’t think we can transition all existing products into a new framework. A new set of products may have to evolve to meet end-investor demand

Subadra Rajappa, Societe Generale

“Swaps order books haven’t really taken off in the way that was envisaged and there’s a limited amount of activity. The fact is there’s lots of really rich swaps data elsewhere and a huge amount of liquidity elsewhere. Any move to RFQ prices doesn’t have to be exclusive as you can take prices from all over the place,” says the second source.  

Alternative methodologies were considered by the swap rate’s oversight committee in response to non-publication of the US dollar rate during February 2018’s volatility rout. IBA pushed back on alternative data sources, including request-for-quote, on concerns the rate would then be reliant on non-tradeable quotes, according to minutes of the July 2018 oversight committee meeting. 

The nuclear option would be to axe the rate altogether as liquidity in Libor swaps subsides. Swaptions could continue to trade without the rate, but the market would be pushed back into a pre-IsdaFix world, where there was no standardisation and settlement was bilaterally negotiated – often involving disputes. 

According to the European fixed income head, since late 2018 some Sonia-referencing swaptions have begun trading without a generally accepted market benchmark.

“We do trade Sonia swaptions, but it’s quite new. The concept has been around since the financial crisis when clients wanted to see Eonia caps and floors, but these kinds of products aren’t actively traded as the rate curve construction is much more complex when you’re dealing with overnight rates.”

According to Societe Generale’s Rajappa, the answer may lie in new, alternative products, designed specifically for a post-Libor world, rather than attempting to shoehorn Libor-based instruments into an overnight rate environment.

“I don’t think we can transition all existing products into a new framework. A new set of products may have to evolve to meet end-investor demand,” says Rajappa.

Editing by Lukas Becker