A trial period for four rival benchmark administrators to stake their claim as the go-to provider for forward-looking term Sonia rates is proving to be a more arduous assessment than envisaged, as Covid-19 volatility wreaks havoc with underlying markets.
Three of the hopefuls have struggled with a lack of derivatives input data for their versions of the rate; the fourth has produced a rate, but there are questions over its methodology.
The UK financial regulator has signalled it doesn’t intend to endorse a single provider, but expects market participants to coalesce around a preferred rate before it approves term Sonia for use in live transactions in the fourth quarter of this year. Some believe the stress period could help users pick the winner.
“You’re going to have disasters and black swan events, so if you’re going to test a rate, you might as well test it during a time of stress. There are going to be other things happening that none of us expect,” says Stuart Giles, managing director for strategy and development at Tradition – one of two brokers providing order book snapshots to three of the term Sonia providers. The other broker is TP Icap.
While derivatives, bond markets and large parts of the lending market have opted for compounded-in-arrears versions of overnight rates, forward-looking versions that create the interest payment visibility users are used to with Libor are deemed crucial for transitioning niche lending markets away from the discredited benchmark before the end of 2021, when it will be left to die.
Of the four contenders to provide a term rate in the sterling market, FTSE Russell, Ice Benchmark Administration and Refinitiv use Sonia overnight index swap (OIS) quotes as the main input. IHS Markit takes a different approach, using actual prices from Sonia OIS and futures trades.
All four providers have devised a so-called waterfall structure with a series of alternative pricing inputs in descending order of preference. The waterfall aims to ensure the rate continues to be published in times of low liquidity or market stress, in accordance with Iosco benchmark principles and Europe’s Benchmarks Regulation, or BMR.
You’re going to have disasters and black swan events, so if you’re going to test a rate, you might as well test it during a time of stressStuart Giles, Tradition
March provided just such a test of liquidity as firm prices disappeared from screens amid Covid-related trading turmoil. When Sonia swap prices did appear, bid/offers blew out to unprecedented levels: on March 13, spreads on one-month Sonia swaps were seen as wide as 20 basis points, with the instruments quoted at 27.8bp/7.8bp.
“People don’t quote two-way prices when they want to derisk, but there was certainly Sonia activity going on,” says a benchmarks expert away from the term Sonia providers. “Nobody was trading anything they didn’t have to and that’s absolutely the right reaction, but if you’re looking to calculate a benchmark or any other price from quoted data, there are going to be fewer people willing to quote and you have to revert to reported data.”
While the lack of quotes forced some administrators to reach for lower-ranked data to feed the proposed methodologies, IHS Markit says it was able to produce a rate during this period without breaching the top of its input waterfall.
“Despite the significant market stress and uncertainty, we’ve used transaction data at level one of our calculation for every day and every tenor point in 2020,” says Ross Allen, global head of term risk-free rates at IHS Markit.
The vendor’s level one inputs for term Sonia combine proprietary information on spot and forward-starting OIS transactions from the administrator’s MarkitSERV trade processing arm with Sonia futures data.
The Sonia swaps transaction data that the firm used during the period of market stress was mainly voice-brokered activity. Overall trade volumes were enough to exceed the methodology’s baseline £1 billion ($1.24 billion) daily minimum for each of the seven tenors, from one to 12 months.
“Typically what you observe in stressed environments is quotes dry up but you continue to see some transactions being executed because you’ve got real money and real market needs. Although the execution mode may differ, you’ll still see some underlying trading activity occur,” Allen says.
Markit’s transaction-based methodology differs from guidance by the UK regulator for technology and pricing vendors aiming to provide a term Sonia rate. The Financial Conduct Authority has urged candidates to base their proposed rates on quotes submitted to central limit order books (Clobs), as part of its drive to stimulate Sonia activity on lit venues. The methodologies from FTSE Russell, Ice Benchmark Administration and Refinitiv follow this guidance.
Tim Bowler, president of IBA, says: “We know that the working group wants central limit order book data to be the focus point and we also know that Sonia futures data is key. Putting those two together gives us confidence that a rate can be produced every day.”
IBA, along with FTSE Russell, uses Sonia futures as next-level inputs after firm OIS quotes.
Bowler adds: “IBA is seeking to move at an appropriate pace knowing that the working group is looking for a workable solution in the fourth quarter of this year.”
FTSE Russell and Refinitiv did not respond to a request for comment.
The prospective term rates from all four vendors are currently being tested internally and are not yet published. IHS Markit hopes to begin publishing a test version of its term Sonia rate in May. IBA has published a futures-based term Sonia on its website since October 2018, using data from contracts traded at Ice Futures Europe.
Supporters of the Clob-based approach say it’s too early to judge Sonia order book resilience. TP Icap and Tradition provide streamed prices of Sonia swaps on their trading platforms, iSwap and Trad-X, respectively. They are thought to be the only two Clobs offering this service.
Tradition’s Giles says: “March was pretty extreme and I don’t think I’ve ever seen anything like it. The order books had a few days with no streams, but the Sonia order books came back very quickly.”
Quotes returned to Trad-X by late March with at least five dealers quoting continuously. Available liquidity is good at the best prices, Giles says. “We’re at the early days of forming a Sonia term and there’s a huge variation among those streaming, but if I look at the top of the book it’s a decent market,” he says.
On TP Icap’s iSwap platform, uninterrupted streaming of Sonia swaps resumed on March 25, with five to eight dealers consistently making prices – albeit at wider bid/offers – according to a spokesperson.
Vendors are currently receiving daily snapshot data from the two brokers and merging that data to produce term fixings according to their own methodologies. Some are also understood to be seeking access to the brokers’ live order book streams.
The Clob-based term Sonia approach, which was initiated by the Bank of England’s working group on sterling risk-free rates, takes its cue from the Ice swap rate, an IBA-administered rate that measures the price of Libor interest rate swaps from one to 30 years. The Ice swap rate is determined using streamed prices on Clobs.
Gaping holes have emerged in this rate in recent months, leading some to question the viability of the methodology as a whole. Vanishing screen liquidity saw the US dollar version of the swap rate fail to publish in any tenors throughout March, while sterling rates were patchy.
The administrator is in the process of adding alternative data sources – including indicative request-for-quote prices – to bolster the rate’s resilience in times of stress.
When you look at how the swap market is used in the short end of the curve compared to the long end of the market, we see two different animals with different end-users who have differing hedging needsKevin Liddy, Solum Financial
Comparisons between term Sonia and the struggling Ice swap rate may be overdone, some say, owing to differing dynamics in short-term and long-term swap markets.
“When you look at how the swap market is used in the short end of the curve compared to the long end of the market, we see two different animals with different end-users who have differing hedging needs,” says Kevin Liddy, principal at derivatives consultancy Solum Financial.
“Anything to do with hedging of short-term funding needs, managing risk to interest rates such as Bank of England base rate, repo or Libor spreads, is via the Sonia market, so demand and activity in the short end is always there, whereas in the longer end, supply and demand can ebb and flow or can all be one way,” he adds.
For example, traded Sonia swaps notional outstripped Libor swap volumes almost two-to-one in the first quarter of 2020. Sonia-linked interest rate swaps traded $8 trillion equivalent during the period, compared to $4.18 trillion equivalent of sterling Libor swaps, data from the International Swaps and Derivatives Association shows.
The development of term fixings could help to bolster order book liquidity, as it would pave the way for electronic platforms to run auctions, much like the foreign exchange market’s 4pm fix in London. The auctions enable matched bids and offers to trade at a price that is deemed to be fair and consistent, encouraging further participation.
Official sector support for quote-based term Sonia stems in part from scant liquidity in spot-starting OIS transactions. An estimated 90% of Sonia swap trades are forward-starting, focusing on Monetary Policy Committee dates.
Building a transaction-based benchmark from forward rates requires proprietary modelling or interpolation and is described by one critic as “trying to fit a square peg in a round hole”.
To incorporate forward-starting instruments, IHS Markit constructs a base curve using futures settlement levels and overlays it with swap transactions. Forward-starting instruments are then assigned on the appropriate business days to which they relate and the rates are compounded up to the appropriate periods. For example, a spot-starting one-month swap comprises 20 to 22 observation days, which would all be inputs into the benchmark. A one-month swap starting in two weeks’ time would be allocated only to the last two weeks of that period, with the rate compounded up for those business days it relates to.
The aim, according to IHS Markit, is to maximise data quantity and quality. By using futures, spot and forward-starting OIS, the rate combines high trade count and high notional. On a typical day, the number of futures trades is around five times higher than the number of OIS trades, while volume of OIS transactions is around 10 times that seen in futures markets.
Futures and OIS are quite complementary with different trading styles, different participants and the number and size of transactions is quite differentMarcus Schüler, IHS Markit
“Futures and OIS are quite complementary with different trading styles, different participants and the number and size of transactions is quite different,” says Marcus Schüler, head of benchmarks at IHS Markit. “When you look at BMR and Iosco principles, we feel that quantity and size of trades makes it a very robust benchmark, so we like the combination of the two.”
Critics counter that the interpolation method makes it hard for users to model the benchmark to check the validity of rates or predict future price movements.
Some even question why IHS Markit would take the trouble to produce a rate that goes against the methodology recommended by the UK regulator, particularly as the benchmark will be relevant for only an estimated 10% of loans by value, according to a January paper by the working group on sterling risk-free rates.
“All these methodologies are fine and replicable and will work for the limited usage that term Sonia is going to have. But if the [Clob-based] model laid out by the working group is what banks and end-users thought made the most sense, why fight that when you’re producing a credible rate that is only going to have a niche usage?” says a second benchmark expert.
However, it’s not clear how – or whether – regulators will stop lenders and borrowers from using a BMR- and Iosco-compliant benchmark more widely if participants end up coalescing around one of the term rates.
Editing by Alex Krohn
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