Debate around risk-free rates (RFR) and whether they are suitable for all products clients may wish to transact in is taken up by a panel of experts, who explain the areas in which RFRs are most and least suitable, the challenges for market participants in the transition to RFRs from Libor and the most valuable features expected to influence the uptake of the fallback rates
- Harry Lipman, Global derivatives product manager, OTC derivatives, Bloomberg
- Axel van Nederveen, Treasurer, European Bank for Reconstruction and Development
- Chris Dias, Principal, KPMG
- Jason Manske, Head of derivatives and liquid markets, MetLife Investment Management
- Nassim Daneshzadeh, Partner, PwC UK
- Karyn Daud, Partner, PwC UK
- Justin Keane, Principal, PwC US
- Frank Serravalli, Partner, PwC US
How suitable are alternative RFRs for clients’ needs?
Justin Keane, PwC: Clients represent a diverse group of market participants, including issuers, investors, borrowers and lenders. Generally, clients make three key points on the suitability of alternative RFRs:
1. All clients have emphasised that price visibility and liquidity on products that reference alternative RFRs is critical to the development of a transparent, liquid market. Much of this is mechanics, but the economics and liquidity have to be there. Clients are beginning to appreciate the ‘push-pull’ dynamic. Arguably, issuers and lenders must have product to push, but investors and borrowers can accelerate supply by demanding the product.
2. Some clients may be comfortable with arrears setting rates, and some clients may have a preference for a forward-looking term rate. Select clients may be economically indifferent if simply swapping back to fixed at the right price, but many believe the transition will be operationally easier if an in-advance setting rate is available, a point that might grow in importance given the current capabilities of vendor and other platforms.
3. While borrowers may like removing bank credit risk, lenders and investors may not – perspective is important. Some borrowers may be happy that they are no longer implicitly paying for the bank funding costs embedded in Libor, although ultimately some of those risks need to be covered. Other investors may prefer the higher yield embedded alongside bank funding risk.
Ultimately, suitability evaluation is also dependent on understanding the RFRs and how they are being used operationally in financial instruments, and understanding how the risks to each of the parties to a transaction are being evaluated and addressed.
Jason Manske, MetLife Investment Management: I think we must first ask: “What is the long-term suitability of polled rates such as Libor, which increasingly do not reflect actual underlying transactions?” RFRs – such as the secured overnight financing rate (SOFR) in the US – are based on hundreds of billions of actual daily transactions and are thus suitable as benchmark interest rates.
The most common complaint I have heard is that lenders would like a rate more correlated to their borrowing costs and reflective of the broader credit environment. It is true that RFRs are unlikely to respond in the same manner as Libor did during a recession, but it is important to note that lenders borrow far less in the wholesale unsecured markets that Libor is meant to represent, and that they could use the derivatives markets to partially hedge any remaining risk.
Axel van Nederveen, European Bank for Reconstruction and Development: The beauty of the current construct of the RFRs is that they are the best reflection of the base rate for money in a particular currency. As such, they are the transparent benchmark for the current base level of interest rates. An added benefit is that the methodology is transportable to less developed markets. As in most systems, overnight maturity tends to be the most actively traded and – in some jurisdictions – the only maturity traded.
But the debate is whether RFRs are suitable for all products that clients have or might want to transact in. The big difference between current RFRs and term Libor is that Libor encompasses two other major elements – the cost of term liquidity for the banks and interest rate change expectations. I am ignoring the bank credit component people often talk about, as only in times of systemic crisis will this premium become significant.
The reason many customer products are linked to term rates is that cash products require banks to supply cash to their clients and the cost of cash is dependent on the maturity of the loan or product being offered. This can be solved by effectively charging a margin for the product that reflects not just the client’s credit risk but also the estimated cost of liquidity for the bank for the term of the loan.
This leaves one overriding question – whether clients prefer or need to know their projected cashflows well enough in advance to deal with the ‘in arrears’ methodology, which only allows for a short period between knowing the exact amount of the payment and the actual payment date.
Chris Dias, KPMG: Working groups and regulators worldwide have endorsed replacement benchmark rates for their respective jurisdictions. These rates do not perfectly replicate the Libor rates they are intended to replace and, in some cases, are quite different. These differences pose a number of challenges and will complicate adoption of the new rates. However, the new RFRs can be made workable for all clients with some level of effort and, more importantly, if market participants are willing to embrace the differences. Market participants will need to get comfortable with the challenge of overnight rates, the absence of term rates, compounding- or averaging-in-arrears, basis differences, volatility differences, and a number of other conceptual and structural differences.
Harry Lipman, Bloomberg: RFRs are suitable for many market participants, but still present significant challenges for certain firms that use swaps to hedge a credit component of a trade or have a need to know the exact coupon payment well in advance of the payment date.
RFRs are commonly used by sell-side banks and major buy-side institutions in over-the-counter (OTC) markets for use in products such as overnight index swaps (OIS). Given the overnight nature of RFRs, they currently have no established forward-looking term fixing, the lack of which means there will be operational challenges for some firms, as they will need to use a backward-looking compound-in-arrears fixing rather than a forward-looking term Libor tenor. This could present a headache for end-users such as smaller buy-side institutions that might lack the necessary infrastructure to handle the uncertainty of an arrears-style coupon payment, especially as it pertains to retail cash products.
Another key issue is that RFRs lack the credit and liquidity component captured within Libor. This is primarily challenging for institutions wanting to continue to hedge their credit or liquidity risk with a swap. In times of financial instability, investors migrate towards risk-free securities and, as a result, one could actually see an RFR move lower while credit spreads and borrowing costs move higher. This could create a mismatch between the credit product and the RFR used as a hedge.
Do we need forward-looking term rates? What challenges does their development represent?
Harry Lipman: The US Federal Reserve Alternative Reference Rates Committee (ARRC), the UK Financial Conduct Authority’s (FCA’s) Official Sector Steering Group and other regulatory bodies have stated that the Libor transition should not wait for forward-looking term-rate fixings to be developed, but instead use the compound-in-arrears methods. This is reflected in the International Swaps and Derivatives Association’s (Isda’s) choice of RFR methodology for Libor fallback (for OTC derivatives). The ARRC consultation on cash, loans and other products has also suggested similar guidance on fallback of these products.
While many clients have expressed a desire for forward-looking term rates to help ease the adoption of RFRs for loans and other products, there is a natural evolution the market must follow before it gets there. Given the need to meet International Organization of Securities Commission (Iosco) standards, and the current lack of volume/liquidity in the trading of short-dated maturity instruments on the US dollar SOFR (and on other currency RFRs), it is challenging to produce a trusted and accepted forward-looking term-rate fixing, and is expected to remain challenging for the next few years.
Jason Manske: Some market participants feel we need forward-looking term rates to ease the burden of transition for smaller and less sophisticated market participants. The most viable term rates are likely to be derived from derivatives markets, including SOFR futures and SOFR swaps in the US. Liquidity in the SOFR futures and/or swaps market will need to continue to grow in order for SOFR term rates to be Iosco compliant.
Chris Dias: Forward-looking term rates are extremely important from the perspective of market adoption and client acceptance of the new RFRs. A published term structure of interest rates across multiple tenors allows firms to better plan and anticipate cashflow. Many firms also rely on forward-looking interest rates as a critical input into decisions concerning hedging. The primary challenge to developing a robust term structure for benchmarks is rooted in the principles set out by Iosco that are related to acceptable benchmarks. A critical precept for regulators is that rates be underpinned by market transactions, which in turn are highly dependent on sufficient liquidity being developed in futures and swaps across the various tenors. While some new RFRs are well on the way to developing a term structure, growth in liquidity is still nascent for other RFRs – SOFR, for example – with continued demand for Libor-based products posing the greatest impediment to growth.
Frank Serravalli, PwC: Need or want? The market is accustomed to forward-looking rates for operational ease. In the near term it may be easier for the systems and processes, many of which are aged, to onboard forward-looking versions of the term RFRs.
However, the market has also demonstrated that overnight rates can be successfully used in cash instruments. For example, SOFR debt issuances have involved coupons paying less frequently – for example, quarterly based on a compounded or averaged SOFR – so the instrument more closely mimics the coupon conventions of prior instruments. Developing a common market convention for the calculation by product type is as important to increasing market adoption as trust in the rate and visibility into the spread related to term.
With respect to the creation of term fixings, one view is that forward-looking term representations of the RFRs may be created from the derivatives markets. Proponents of this view argue it will have a number of advantages:
1. RFRs will be built on transactional data – for example, notional amounts already in the hundreds of billions in CME futures alone, compared with around $500 million of transactions backing US dollar three-month Libor.
2. Direct linkage to the derivatives markets for hedging and risk management, reducing basis risk in the system.
3. Advance setting rates can be much more readily embedded in existing – and, in many cases, archaic – loan systems.
There are, however, alternative views in the market. For example, a term rate for cash instruments could be achieved by issuing cash instruments at different tenors. This incremental component approach could drive and support demand from the buy side and enhance market depth. The routine and continued issuance of cash products at different tenors in the marketplace could naturally create a forward curve.
Markets must determine which solutions are adopted, but participants should consider the interaction between cash and derivative instruments. Consistent approaches across asset classes will facilitate risk management and accelerate liquidity.
Axel van Nederveen: Part of the problem with Libor was that the stack of transactions linked to it is dominated by interest rate derivatives, which represent up to 80% of the total notional. In the first quarter of 2019, 90% of interest rate derivatives were centrally cleared. It is already accepted that these will not need a term fixing.
On top of that, a large proportion of the notional amount of interest rate derivatives consists of forward rate agreements (FRAs). Roughly 40% of all interest rate derivatives were FRAs, mainly used by banks to manage their Libor-fixing risk. All three elements point to a large reduction of notional outstanding linked to any term rate. This means the potential incentive to manipulate them decreases markedly even before you consider how you can eliminate this risk further through their construction.
As long ago as 2014, the Market Participants Group on Reforming Interest Rate Benchmarks indicated that the OIS market provides a good basis for a forward-looking term rate.
But one of the missing elements is that OIS is still an OTC market. If you
can force it onto a transparent marketplace, an index can be constructed
with a benchmark administrator providing governance over the process
and the methodological refinements that can be used to minimise the risk
The benchmark cannot be transaction-based, as an average price for the day, but will have to be constructed with a point-in-time measure. To do this, you need access to continuously streamed prices from a sufficient number of providers. This is likely to happen as the FCA has approached the major dealers to do just this. Then it is up to the benchmark administrators to decide how they construct the benchmark according to Iosco principles. There are a number of ways of minimising manipulation risk, including using relatively long, potential measurement windows with small time slices.
But the main deterrent will be in the transparency of activity through the electronic market.
I haven’t mentioned the liquidity or fear of lack of liquidity in the underlying market – for a reason. Once Libor is gone, all short-term interest rate risk management will have to be done through the OIS market. Liquidity does not need to equate to a large volume of trades. It is more the ability to trade large volumes without moving the pricing of the asset you buy or sell. This, by definition, is the case in the short-term interest rate markets.
If clients want to use a forward-looking term rate, manipulation risk can be managed.
What mechanisms can transfer legacy Libor swaps to RFRs?
Nassim Daneshzadeh, PwC: Firms are currently looking closely at their legacy interbank offered rate (Ibor) swap books to decide on the most appropriate transition strategy.
For the swap book, there are multiple means by which firms can look to transition legacy swaps into RFRs. These include proactive steps to transition the book prior to the Libor rates ceasing at the end of 2021 through the use of compression, unwinds or simply repricing the derivatives from Libor into alternative rates. However, for operational ease, the more firms can do in bulk the better.
Many firms will also look to rely on the Isda protocol to provide a fallback in their current contracts, providing a safety net if they are unable to transition into the new rates prior to Libor cessation. However, firms will need to ensure they are not overly reliant on the fallbacks as their primary means of transition, as that may cause significant operational risk, given the impact on valuation, risk, payment and accounting systems that would happen simultaneously at cessation.
Firms will need to assess how well the fallback methodology in the protocol will work, not only for the linear book, but also for their non-linear swaps.
The majority of these transition methods come with some transfer value, and therefore ‘winners’ and ‘losers’. While firms will look to minimise this, avoiding it altogether is unlikely.
Chris Dias: Transferring legacy swaps to the new RFRs is not a simple exercise. Robust fallback language should help with the process, but broad-based market adoption is critical to success. While firms may recognise the need to adopt new RFRs, their willingness to take the plunge will be tempered by numerous factors, including contractual considerations, systems, models and infrastructure challenges, client or counterparty willingness, appropriate basis adjustments, economic impact and timing. Leveraging the work of industry bodies – such as Isda protocols and statements by central counterparties (CCPs) – third-party vendors and advocacy groups will solve some of the issues, but the onus to move forward is borne by each institution.
Axel van Nederveen: A key component in the transition process will be the spread calculation methodology chosen by the market. The first Isda consultation showed a clear preference for setting in arrears, with the spread calculated as a historical mean or median. What is still open for consultation in 2019 is the length of the historical lookback period. If the lookback period is long enough – more than five years – it can be perfectly rational to convert en masse at the time of Libor’s demise. It is clean and simple and adheres to the Isda protocol of being operationally easy to achieve while you are converting at a perfectly rational level. You could convert early but would probably only do so if transactions could be closed at levels better than the projected conversion spread. The closer you get to the date the more precise you can estimate this level.
One potential incentive for converting early – once the methodology is set – is that having the converted contracts will give you an RFR plus a spread. The presence of a fixed spread implies you will now have interest rate risk for the remaining life of the contract. This can be averted by effectively ‘re-couponing’ the trade to a flat RFR transaction.
Is there sufficient liquidity in RFR products? How can it be improved?
Karyn Daud, PwC: The short answer is not yet – but liquidity is growing.
While progress has been made in increasing liquidity in the RFRs, this liquidity is still uneven across currencies and products. In the UK, the sterling overnight interbank average rate (Sonia) is an existing rate and is therefore used in significant volumes of derivatives and bond transactions. However, volumes of SOFR swaps and futures are still playing catch-up – as is the corporate loan market as a whole, where there has been minimal activity to date. PwC expects activity in the latter to pick up over the last quarter of 2019 and accelerate through 2020.
Actions that will drive success and can increase liquidity in RFRs in the marketplace include:
- Aligning clearing-house timelines and methodologies
- Providing regulatory, accounting and tax relief
- Developing term rates
- Developing new products by banks to test new structures, identify and remove operational bottlenecks
- Banks educating clients – especially regarding cash products
- Increasing investment in new RFR products by the buy side
- Developing operational implementation capabilities by firms and vendors.
Chris Dias: Liquidity is slowly growing as market participants begin to see the new RFRs as viable alternatives. A growing number of firms have pulled the trigger to support the new RFRs – new RFR debt issuance has gradually increased, transaction volumes in swaps and futures have seen steady growth, and month-on-month volume continues to rise. Nonetheless, this growth pales in comparison to the issuances and transaction volume referenced by Libor. Liquidity in RFR products will improve substantially when the availability of Libor products declines, and market developments – such as price alignment interest and collateral discounting based on RFRs – are fully instituted.
Axel van Nederveen: In derivatives it will come; I’m not that worried about the eventual depth of that market.
Jason Manske: The US markets could benefit from more liquidity in SOFR-linked instruments – especially in instruments with tenors longer than two years. However, it is important to note that SOFR was first published in April 2018 and liquidity in SOFR futures, SOFR OTC derivatives and SOFR-linked cash products has been increasing steadily since its introduction.
Liquidity in the risk-free benchmark markets can be improved through wider adoption by investors, lenders, hedgers and speculators. The rate of adoption is driven by several factors, including technological and operational considerations, removal of regulatory uncertainty around issues such as the treatment of legacy Libor derivative positions in a transition, as well as the tax and accounting treatment of new benchmark rates.
Additionally, wider-spread use of SOFR derivatives should occur once the clearing houses – LCH and CME – shift to SOFR discounting. This will likely cause derivatives dealers to increase their use of SOFR-based hedges, further improving market liquidity.
What challenges do participants face when trading instruments, such as those for cross-currency interest rate swaps across secured and unsecured benchmarks?
Jason Manske: Cross-currency swaps represent one of the biggest challenges to the derivatives market in the transition to new benchmark rates; however, the secured versus unsecured benchmark issue is not a significant consideration.
The potential for different fallback mechanisms, spread adjustments, interest calculation and payment conventions across currencies creates the possibility for additional operational and valuation issues. Potential issues with beneficial instruments such as cross-currency swaps highlight the need to transition to new reference rates in a globally co‑ordinated manner.
Chris Dias: Individual Libor swaps have had the benefit of sharing common constructs – a single regulator and administrator, being published at the same time, and all being unsecured benchmarks. This commonality was key to the success of the cross-currency market. The new RFR paradigm presents some new challenges to the cross-currency market in that there are multiple regulators and administrators, publishing times vary and some new benchmarks are secured while others are not. Global working groups have provided recommendations for addressing some of these issues; however, firms must still contend with the challenge of entering swaps where one leg is secured and the other is not. Secured and unsecured rates act (trade) differently in times of stress, resulting in increased basis volatility. Market participants will need to contend with this extra consideration when entering into cross-currency swaps referencing the new RFRs.
Does more need to be done to co‑ordinate post-Libor transition across swap classes?
Axel van Nederveen: At the moment, co‑ordination is at the overall RFR working group level in the UK. It allows the different asset classes to work on their own issues surrounding the changeover. Even so, once there are conflicting interests it is still hard to bring these to a conclusion as, by construct, they almost always need consensus.
What factors are likely to influence the choice and uptake of the fallback rates?
Harry Lipman: For OTC derivatives, Isda has been successful by building consensus surrounding its choice of Libor fallback calculation, which entails a compounded-in-arrears RFR coupled with a Libor/RFR spread adjustment by working with market participants, regulators and vendors such as Bloomberg. With one additional consultation scheduled for later this year to fine-tune the relevant methodology parameters, the adoption outcome is expected to be relatively positive. In addition, Isda recently identified Bloomberg as the fallback adjustment vendor to calculate and publish adjustments related to Libor fallbacks, based on the exact methodology and parameters being determined based on industry consultations.
For cash products, consensus is more challenging as many products and securities exist in the retail world and can comprise more than two parties, unlike interest rate swaps. For example, a typical mortgage product involves the mortgagee, mortgagor, custodian, issuer and investor. Given the nature of each security having its own unique legal documentation, assessing the fallback language for every security in a portfolio can be formidable task. Bloomberg currently provides fallback language for cash securities, enabling asset managers and other institutional investors to assess fallback ramifications.
In addition to calculating and distributing this fallback data (for derivatives) and fallback language (for cash products) to the industry, the calculations will be integrated within the Bloomberg analytics and portfolio solutions to support Libor transition globally.
Chris Dias: The choice and uptake of fallback rates will be largely influenced by the availability of an acceptable replacement rate and its associated term structure – or methods to derive a term structure – market consensus on conversion mechanics, ease of implementation and an observable trigger. Each of these factors presents unique issues and questions. While industry consultations have taken place and recommendations exist or are forthcoming, the shortcomings of proposed fallbacks make widespread adoption challenging.
Axel van Nederveen: One problem is the so-called ‘third fallback trigger’ – the pre-cessation trigger. The Isda consultation on this trigger clearly showed a complete lack of consensus in the industry. We have the main derivatives dealers who fear that the uptake of the Isda fallback protocol could be selective and don’t want this ambiguity, while the buy-side clearly has a preference for their clients not being exposed to a benchmark that has been deemed ‘non-representative’.
I understand the reticence of the industry about the trigger. The continued presence of a published Libor rate while fallbacks are triggered, if the pre-cessation trigger is part of the fallback language, might mean more clients will choose not to use the protocol. They have the option to wait and see what is in their best interest at the point at which the fallbacks are triggered.
The other issue – which I’m confident will be resolved – is that the accounting standard boards need to give certainty that the conversion itself will not lead to a change in the hedge accounting designation of instruments and their associated hedges.
What operational challenges does the transition present for different market participants and what principles should guide their strategy?
Jason Manske: Most market participants have similar operational challenges – although the scope of those challenges will vary by size of the institutions, the nature of their businesses and the extent to which they utilise derivatives. However, all participants must go through the same processes of Ibor exposure identification, remediation/transition, and adoption of new benchmark reference rates. Entities with extensive retail products tied to Ibors will likely have the most challenges as they must perform significant outreach, communication and education to their retail client base. Smaller institutions that face resource constraints will need to outsource more of their transition efforts to vendors.
Some common principles include:
- Start early – you should have started already
- Prioritise the exposure identification process as it will be very difficult to identify 100% of your firm’s exposure
- Plan systems enhancements and discuss the transition with providers of systems/tools
- Reduce or stop adding new Ibor exposure
- Utilise industry-developed fallback language for new Libor transactions
- Begin transacting in products linked to the new benchmarks.
Karyn Daud: Four of the largest execution challenges that plague Libor transition teams – especially at large, globally diverse organisations – include consistent client outreach and communication; remediation of thousands of client contracts; the scale of concurrent technology upgrades; and adapting, tracking and monitoring changes to the balance sheet, risk and capital. Scarcity of time and budget, and the large number of internal and external stakeholders involved exacerbate these challenges.
Consequently, managing the operational execution risks associated with Libor transition is one of the most significant board-level Ibor transition issues for market participants – on par with legal, conduct and economic risk.
So, what can market participants do to manage these challenges and risks? PwC advises clients to start planning early, use scenarios to prepare for eventualities and connect the operational change activities – front to back – to your transition strategy. Even amid the risks, Libor transition represents an opportunity to improve service to customers, clients and counterparties. Design your programme with this mindset, ensuring the business is engaged and leading the charge with your clients.
Harry Lipman: To best mitigate potential challenges, participants should check existing portfolios for Libor dependence and determine whether there is any Libor fallback language for their OTC derivatives and cash instruments.
Participants should understand any regulator-driven or market structure initiatives that could affect their instruments across all currencies and need to be able to assess their ability to trade out of existing positions, and try to limit any additional Libor exposure from new trades.
At a minimum, even if participants have no existing Libor-dependent portfolios, they will need to have RFR OIS-type infrastructure in place, especially as it pertains to supporting a compounding-in-arrears-style convention. This includes appropriate data feeds and market risk/value-at-risk models. Additionally, any preparedness for transformation from existing Libor instruments to RFR OIS instruments should include Isda Libor fallback infrastructure.
For OTC derivatives portfolios, there are several aspects for clients to consider when transitioning their derivatives from Libor to RFR. For bilateral uncleared portfolios, clients can repaper or negotiate revisions to existing Isda agreements and credit support annex portfolio netting sets. For cleared trades, the CCP may conduct multilateral auctions and other protocols to move existing legacy Libor swaps/legs to RFRs. For either bilateral or cleared trades, a closeout of existing Libor trades coupled with a new trade that references the RFR index may be initiated or, alternatively, a basis trade where the Libor legs offset may be initiated.
It is important to begin testing portfolios and analysing risk to help ensure the transition goes smoothly well ahead of the potential Libor sunset in 2021. The process can include impact analysis on changes to Isda agreements, preparing for price alignment changes at the CCPs, and running what-if analysis on risk and valuation changes associated with migration of derivatives over to RFRs. Bloomberg’s derivatives analytics platform, coupled with leading execution and order management platforms, enables users to assess valuation and risk ramifications, as well as seamless execution for Libor transition portfolio changes.
Chris Dias: All market participants will face operational challenges as a result of the Libor transition – and they will be more acute for some than others. Impacted firms will need to identify and change systems, models, calculators, platforms and business processes affected by the transition. Understanding change dependencies and the timing of each change will be critical to achieving a cost-effective transition.
The respondents to Risk.net’s questionnaire were speaking in a personal capacity. The views expressed by the panel do not necessarily reflect or represent the views of their respective institutions.
Copyright Infopro Digital Limited. All rights reserved.
You may share this content using our article tools. Printing this content is for the sole use of the Authorised User (named subscriber), as outlined in our terms and conditions - https://www.infopro-insight.com/terms-conditions/insight-subscriptions/
If you would like to purchase additional rights please email [email protected]
Copyright Infopro Digital Limited. All rights reserved.
You may share this content using our article tools. Copying this content is for the sole use of the Authorised User (named subscriber), as outlined in our terms and conditions - https://www.infopro-insight.com/terms-conditions/insight-subscriptions/
If you would like to purchase additional rights please email [email protected]