Canada term rate plan sparks ‘inverted pyramid’ debate

Some dealers push back on forward-looking Corra proposal amid low derivatives liquidity

Concerns-over-Canadian-term-rate-plans montage

Canada’s corporate borrowers are hoping for access to a forward-looking interest rate benchmark following the demise of the Canadian dollar offered rate (CDOR), but some worry that derivatives linked to the Canadian overnight repo rate average (Corra), CDOR’s anointed overnight successor, may not be liquid enough to ensure a robust term version.

“Derivatives dealers and some of the bank treasuries are already pushing very much against the creation of a term Corra, because the liquidity constraints against it are going to be quite difficult,” says a rates trader at a Canadian bank.

Refinitiv’s benchmark administration business said in May it is killing off CDOR after June 28, 2024, firing the starting gun on a complex rate-transition process.

As an overnight rate, Corra must be compounded in arrears to replicate lending terms, meaning borrowers lose visibility on their interest payments. A forward-looking term version built from Corra derivatives prices would address this problem, but traders warn such a benchmark may repeat the ‘inverted pyramid’ that regulators are keen to stamp out, in which trillions of dollars of contracts came to rest on rates built from a dwindling pool of transactions.

“I think the market is just reluctant to have a term rate that puts the dealers and the banks back in this situation… where you are still dependent on a relatively small number of players in the market for the creation of the term Corra rate,” says another Canadian banker.

The rates trader adds that there is currently a lot of debate, “certainly in the derivatives space, over whether Canada can support an overnight in-arrears market and a term market as well”.

Canada is the latest jurisdiction working to move its lending and derivatives markets away from a credit-sensitive rate set by a panel of banks and towards a risk-free benchmark, following similar processes in the US and the UK.

The Canadian Alternative Reference Rate working group (CARR), which recommended CDOR’s cessation in December, warned a shrinking market in bankers’ acceptance (BA) paper threatened the viability and robustness of CDOR, which underpins trillions of dollars’ worth of transactions annually.

The International Swaps and Derivatives Association has confirmed that Refinitiv’s decision to kill off CDOR represents an index cessation event, triggering the calculation of fallback rates for legacy contracts.

The liquidity constraints against [term Corra] are going to be quite difficult 
A rates trader at a Canadian bank

Following confirmation of the cessation date, CARR opened a consultation into whether it should move forward with a term version of Corra.

Robert Walton, head of interest rate benchmarks at Refinitiv, tells there is a lot of interest in some kind of term rate to replace CDOR.

“I’m sure the demand is there,” he notes, pointing towards “specific use cases whereby a forward-looking rate is required… It’s some aspects of the loan market and trade finance.”

The Canadian banker agrees that most corporate borrowers would prefer visibility into their interest payments. “Corporate commercial customers would prefer to have a term rate than an in-arrears rate,” he says.

“There’s a small percentage that would probably be able to contend with an in-arrears rate given the appropriate time and setup, but if you just asked they would say, for any number of reasons, they would rather have a term rate.”

Some believe the need for term Corra may be less desperate than for term SOFR in the US, where an effective ban on new Libor trading took hold at the start of this year.

In the US, swaths of corporate lending activity were pegged to Libor. By contrast, most Canadian corporate lending is linked to the prime rate.

“A lot of lending in Canada is prime based,” says the Canadian rates trader. “They use the overnight rate or the prime rate, and I would say there is much more of that than there is actual BA or CDOR-related lending.”

Canada’s prime rate tends to trade at least 200 basis points higher than the Bank of Canada’s overnight rate. The overnight rate is currently 2.5%, following a 100bp interest rate rise on July 13, pushing the prime rate to 4.70%.

Contenders, ready?

The alternative reference rate working group’s consultation closed on June 30, but the results are yet to be made public. If CARR opts to push ahead with term Corra, a request for proposal will likely be launched in the next two months, according to a timetable published by the group.

Contenders to calculate such a rate include Canadian exchange operator TMX Group, data providers like Refinitiv and international exchanges such as CME and Ice – both of which have benchmark administration arms and already publish term versions of the secured overnight financing rate, or SOFR.

Luc Fortin, president and chief executive of the Montreal Exchange, says the exchange and its parent TMX is “at the table, trying to provide solutions.”

“I think we have all of the tools” to introduce new benchmarks to support the Canadian transition process, Fortin says. But he adds that “it’s still very early days” in the transition process and there is a long way to go before any final decision is made on what a Canadian term rate will involve.

In the US, term SOFR has become the favoured benchmark for leveraged loans and other types of corporate borrowing. The index is calculated by the CME Group and based on SOFR futures pricing data. Currently, derivatives are only permitted on the rate where they represent direct end-user hedges of cash instruments.

Calculation of a forward-looking term Corra rate would likely be constructed from Corra futures – a market only in its infancy.

An alternative option could be to base term Corra on the overnight index swap (OIS) rate rather than futures. This methodology underpins term versions of the UK’s sterling overnight index average, or Sonia, which is published by Ice Benchmark Administration and Refinitiv.

“The advantage of OIS is that it’s quite an easy thing to replicate if you have the benchmark,” says Refinitiv’s Walton.

“It’s a point-in-time benchmark roughly centred on a particular point during the day. It’s relatively easy to replicate the benchmark by trading in the underlying OIS contract. I think it’s a little bit harder with futures, but the futures market is a more diverse market and is open to a much broader group of market participants, so the order book may be deep as well,” he adds.

“I think both approaches [futures and OIS] work. Certainly, the market seems to have taken to term SOFR very well.”

The Montreal Exchange launched three-month Corra futures in 2020 and is in the process of building the infrastructure to support a one-month contract. The shorter-dated contract, which is not yet available, would be an important building block for a term rate.

The rates trader says it may be difficult to justify a market split between the two tenors. “We’ve only ever had three-month bankers’ acceptance futures,” he says, referring to the market in bank-backed corporate paper which underpins CDOR.

“So the creation of one-month Corra futures and three-month Corra futures is going to dilute that liquidity.”

Additional reporting by Helen Bartholomew

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