The BBSW reset

Australia has bucked the global trend to move away from interbank offered rates (IBORs) that the market benchmarks off and on which short- and long-term funding is based. Active trading in bank bills makes the bank-bill swap rate (BBSW) a viable base rate for the long term – especially now the Australian Securities Exchange (ASX) has radically overhauled the BBSW calculation methodology as a cooperative effort with market participants.

Laurence Davison Head of Content and Editor KANGANEWS

The paradox at the heart of IBOR reform is that while these rates – which are used as the base rate for trillions of dollars of transactions – theoretically measure the cost of interbank lending, their calculation has not historically been based on observable trading activity.

IBORs are traditionally calculated by a market body or regulator collecting data on interbank lending executed during a daily rate-set window. This information on what are typically OTC trades is collated and aggregated to produce a single base rate that is used for the duration of the trading day.

The first problem is that activity in global interbank markets has tailed off noticeably since the financial crisis. With little or no relevant lending taking place in the rate-set window, banks in various markets were required to use their judgement to estimate the daily IBOR. The rate set was based on the estimated levels submitted by the trading banks.

This approach, while necessary to maintain a daily rate set in the absence of real trading data, left IBORs open to manipulation. In the wake of scandals around rigging of the London interbank offered rate (LIBOR), global regulators decided it was vital to strengthen the framework underlying benchmark calculation.

The need for robust benchmark rates is clear in the volume of financial transactions that use them for pricing reference. The Reserve Bank of Australia (RBA) estimates contracts with a notional value of around US$350 trillion are priced using LIBOR as a basis and that around A$18 trillion (US$13.1 trillion) of notional value uses BBSW as its base rate (see table). In comparison, A$7 trillion of contract notional value is priced off the Australian cash rate.

The challenge internationally is that any IBOR methodology that relies on bank submissions may now be unsustainable. In a May 2018 speech, the RBA’s Sydney-based deputy governor, Guy Debelle, explained: “The banks that make the submissions used to calculate LIBOR are uncomfortable about continuing to do this as they have to rely mainly on their ‘expert judgement’ in determining where LIBOR should be rather than on actual transactions.”

As a result, and in the absence of a widely traded bank-bTheill market, international regulators are looking for alternative solutions. The UK’s Financial Conduct Authority has decided no longer to compel banks on the LIBOR panel to submit pricing after the end of 2021. World markets are currently in the process of identifying alternative base rates before attempting to transfer trillions of dollars of outstanding financial instruments to them ahead of what is expected to be the demise of LIBOR in just three years’ time.

“What emerged after we took on the role of administrator was that many investors had not really been engaged. They had a high level of discomfort about BBSW becoming transaction-based because they were concerned about the implications of being directly involved in the rate set.”

A traded market

The situation is somewhat different in Australia. Unlike LIBOR, BBSW is underpinned by an active market in bills issued by the prime banks.

In fact, there is no shortage of bank-bill trading in Australia – it is just that a lot of the activity is conducted outside the interbank market and with participants that have historically preferred to know the rates they were executing at rather than conducting their own price discovery.

Speaking at the KangaNews Debt Capital Markets Summit in Sydney in February 2016, Debelle noted that, on average, A$1 billion of negotiable certificates of deposit (NCDs) or bank bills was issued in Australia every day. The challenge was that around half the market share belonged to nonbank entities, while the bank component had shrunk to less than 20 per cent from more than 40 per cent around the time of the financial crisis.

“If [nonbank] participants could be encouraged to buy and sell NCDs at outright yields, these transactions would have the potential to make the BBSW benchmark more robust,” Debelle argued.

Nicholas Deppeler, senior portfolio manager, short-term investments at Colonial First State Global Asset Management in Sydney, acknowledges the buy-side preference. “The market developed over the years in such a way that the buy side was typically comfortable transacting at the BBSW rate rather than being actively involved in setting it,” he tells KangaNews. “This allowed us to undertake transactional activity, at any time during the day, at a known rate.”

How BBSW is calculated and how the bank-bill market is traded has wider importance, too. Anthony Kepczyk, portfolio manager at QSuper in Brisbane, explains: “Cash securities form an integral component of our members’ retirement incomes, and while the cash rate and associated products are at historic low yields any cost associated with market changes will detract from these outcomes to a greater extent. Thus any change to the bank-bill market had to be done properly and with rigour to minimise impact across the market.”

The options for the Australian market were to take measures to encourage the trading activity that was taking place to migrate, in whole or in part, into the rate-set window, or to follow the global precedent by facilitating the demise of BBSW and beginning the process of identifying alternative benchmarks.

The decision was ultimately in the hands of regulators, specifically the Australian Securities and Investments Commission and RBA. As early as Debelle’s 2016 speech, the regulators were suggesting that their preference – and that of the wider market – was to retain BBSW and strengthen the calculation methodology.

“Most market participants share our concern about low trading volume during the rate set and acknowledge that changes to the BBSW methodology will be necessary,” Debelle said. “[But] it is crucial that BBSW remain a trusted, reliable and robust financial benchmark given its importance to the financial system.”

The decision was ultimately in the hands of regulators, specifically the Australian Securities and Investments Commission and RBA. As early as Debelle’s 2016 speech, the regulators were suggesting that their preference – and that of the wider market – was to retain BBSW and strengthen the calculation methodology.

“Most market participants share our concern about low trading volume during the rate set and acknowledge that changes to the BBSW methodology will be necessary,” Debelle said. “[But] it is crucial that BBSW remain a trusted, reliable and robust financial benchmark given its importance to the financial system.”

ASX steps in

With this in mind, the Australian Financial Markets Association (AFMA) announced in December 2016 that ASX would take over its role as BBSW administrator. This followed a “highly competitive process” to determine the new administrator and came with an explicit mandate to overhaul the benchmark methodology.

ASX said at the time that, as part of the transition arrangements, it would work with the market, AFMA and regulators on moving to a transaction-based BBSW calculation methodology. This would be based on a volume weighted-average price (VWAP) that would replace the nationally observed best bid and offer (NBBO) methodology as the primary calculation method. “The change in methodology will support the recommendation of the Council of Financial Regulators and reflects the evolution of market practice,” ASX added.

Helen Lofthouse, executive general manager, derivatives and OTC markets at ASX in Sydney, says the exchange knew from the beginning that it was facing a major challenge to develop a new methodology that could be supported by all sectors of the market. But the early stages of the consultation process made it apparent that a major constituency – the buy side, which is also the biggest single trading group in the bank-bill market – was not yet on board. 

“What emerged after we took on the role of administrator and started thinking about a new methodology was that many investors had not really been engaged,” Lofthouse reveals. “They had a high level of discomfort about BBSW becoming transaction-based because they were concerned about the implications of being directly involved in the rate set.”

It was, however, crucial to bring all participants into the tent. The temptation for market users to free ride on a new methodology – continuing to trade at BBSW while letting others do the heavy lifting of actually setting it – would not work given the reduced scale of the interbank market. It would have to be a case of one in, all in to a new rate-set methodology based on whole-of-market trading activity.

With this in mind, the ASX set about a multistep consultation in an attempt to ensure support from all quarters. Lofthouse says the exchange started with a series of bilateral meetings with key market participants to build its own knowledge base about the issues involved and individual players’ perspectives.

It then established a BBSW advisory committee, comprising a number of significant investors, the prime banks, ASIC, the RBA, AFMA and ASX itself.

“The first thing that was clear was that there was a lot of demand for guidance,” Lofthouse reveals. “Market users were telling us they didn’t know what the rules were for trading bank bills where those trades would be used to calculate a benchmark rate. They wanted ASIC to tell them what the rules were, and they didn’t want to be in a position where the regulator came knocking because they had inadvertently done something wrong.”

ASX, in consultation with the advisory committee including the RBA and ASIC, worked on an agreed set of trading guidelines for prime-bank paper which would be used for BBSW setting. The guidelines aim to give market users confidence that, if they trade as described, they will not fall foul of the administrator or regulators.

“I am confident that the system we have in place now would have allowed for a BBSW rate set even during the most challenging times of market liquidity – in other words, the global financial crisis.”

Progressive outcome

The positive outcome for users was a more efficient market. Lofthouse points out that, until the methodology change, BBSW was almost exclusively a voice-traded market in which transactions were executed without visibility of which specific securities would be remitted. This led to a “frantic process” in which participants attempted to reconcile their activity and submit settlement instructions to their custodians and back office in time for same-day settlement.

“It was very manual,” Lofthouse continues. “There was no STP, it was virtually all voice traded and anything that was electronic would hit stops and needed to be manually fixed. We had to produce a rate in real time based on transactions that weren’t making it into the system with full data until just before they settled. This just didn’t work – so we had to dig into the process.”

Kristye van de Geer, senior manager, interest-rate products at ASX in Sydney, adds that it was not just banks participating in the rate set that had to deal with the administrative issues of the old methodology. She tells KangaNews: “Investors will often buy paper that doesn’t yet exist in the system – instead it is created later on for settlement that day. The way we solved the problem was to ask the banks to create the securities and assign ISINs in advance. They essentially set up an ISIN for each day, one year out.”

According to Lofthouse, custodians are also pleased with the introduction of STP to the bank-bill market and have provided highly positive feedback. Trading platforms have seen the market move from being almost exclusively voice traded to being 95 per cent electronically traded with full STP, she adds.

The bottom line is that unless there is a good reason not to do so market participants are now expected to trade within the BBSW rate-set window. ASIC’s regulations around benchmarks and benchmark administrators now include a requirement for ASX, as the BBSW administrator, to write the trading guidelines and for those to be endorsed by ASIC. The regulator also has enforcement power over the guidelines.

“Investors will often buy paper that doesn’t yet exist in the system – instead it is created later on for settlement that day. The way we solved the problem was to ask the banks to create the securities and assign ISINs in advance.”

Positive response

While buy-side participants may not initially have been thrilled at the prospect of a BBSW overhaul that required their trading to move to the rate-set window, the pattern of market activity suggests the drive to rejuvenate the window has been successful.

ASX data indicate daily eligible turnover in the rate-set window averages A$1.8 billion – almost twice the total daily volume referenced by Debelle in 2016. Six-month volume is particularly robust (see chart), though the new methodology can do little to assist a one-month bank-bill market that has been affected by a changing regulatory environment resulting in reduced buy-side demand and sell-side issuance.

A benchmark rate based on real trading activity is only as good as the underlying market. While longer-dated BBSW benchmarks are based on consistent activity – including the three-month rate that is most used for pricing purposes by bond transactions – the lack of investor demand for one-month bills poses a question.

The robustness of one-month BBSW is not just of academic interest. Most crucially, virtually all Australian securitised issuance prices off one-month BBSW. While securitisation market participants say there is no fundamental reason why their asset class could not transition to another base rate – most likely three-month BBSW, which is used for most floating-rate bond pricing – there would at the very least be a transition period to manage. 

The problem is that the investor participants that provide the bulk of demand for longer-dated bank bills are simply not active as buyers at duration as short as one month. At the same time, bank-bill issuers have less appetite to issue at very short duration as it does not help their net stable-funding ratio. 

“The buy side rarely invests to just one month,” confirms Deppeler. “There is activity around the one-month tenor, but it usually involves the switching of existing paper – selling it back to the banks – which means than many trades may not necessarily fall within the rolling eligibility window.” 

With limited volume meeting the eligibility criteria for rate setting, ASX has had to rely on its backup methods for setting the daily rate more often in the one-month part of the curve. The first fallback is the old NBBO approach then, if no quotes are available, Debelle noted in a May 2018 speech that “there are algorithms that can be used to calculate the benchmark for a time”. 

There is enough trading activity to set a transaction-based one-month rate on most days. Lofthouse tells KangaNews: “There is actually quite a lot of volume and we have some ability to set a VWAP rate. But the transactions tend to be in one direction, which market users need to be aware of when they are using the one-month rate.” 

What the new methodology has done is draw activity into the rate-set window. Lofthouse says 88 per cent of bank-bill trading is now occurring in the 8.30-10am rate-set window, a level which exceeded market expectations. 

The robustness of one-month BBSW is not just of academic interest. Most crucially, virtually all Australian securitised issuance prices off one-month BBSW. While securitisation market participants say there is no fundamental reason why their asset class could not transition to another base rate – most likely three-month BBSW, which is used for most floating-rate bond pricing – there would at the very least be a transition period to manage.

The problem is that the investor participants that provide the bulk of demand for longer-dated bank bills are simply not active as buyers at duration as short as one month. At the same time, bank-bill issuers have less appetite to issue at very short duration as it does not help their net stable-funding ratio.

“The buy side rarely invests to just one month,” confirms Deppeler. “There is activity around the one-month tenor, but it usually involves the switching of existing paper – selling it back to the banks – which means than many trades may not necessarily fall within the rolling eligibility window.”

With limited volume meeting the eligibility criteria for rate setting, ASX has had to rely on its backup methods for setting the daily rate more often in the one-month part of the curve. The first fallback is the old NBBO approach then, if no quotes are available, Debelle noted in a May 2018 speech that “there are algorithms that can be used to calculate the benchmark for a time”.

There is enough trading activity to set a transaction-based one-month rate on most days. Lofthouse tells KangaNews: “There is actually quite a lot of volume and we have some ability to set a VWAP rate. But the transactions tend to be in one direction, which market users need to be aware of when they are using the one-month rate.”

What the new methodology has done is draw activity into the rate-set window. Lofthouse says 88 per cent of bank-bill trading is now occurring in the 8.30-10am rate-set window, a level which exceeded market expectations.

“Cash securities form an integral component of our members’ retirement incomes. Thus any change to the bank-bill market had to be done properly and with rigour to minimise impact across the market.”

ANTHONY KEPCZYK QSUPER

Market users – even those with initial misgivings – also appear comfortable with the transition. Deppeler says: “I believe the process worked very well. There was an open forum where participants felt comfortable to discuss what they believed did or didn’t have merit, and there was clearly a shared understanding that reaching agreement on how VWAP would be calculated was in the best interests of the broader financial community.”

Kepczyk and Deppeler credit the ASX for its willingness to listen to all market participants and respond to their queries and concerns. In particular, Kepczyk says the exchange did a good job of approaching the process in a measured and mindful way while recognising the importance of a timely and positive outcome.

Kepczyk adds that the market is working well under the new methodology so far, with ample trading volume to set the rate by VWAP on most days. “It is near impossible to engineer a perfect solution but what we have comes close to being the best possible,” he tells KangaNews. “The good thing is that the working group hasn’t established a new rate set and walked away – it will continue evaluating in the coming years.”

Market participants also appear broadly satisfied that, for as long as there is a traded bank-bill market in Australia, the new BBSW calculation methodology should provide a robust, trustworthy benchmark.

Deppeler adds: “Industry participants are aware of their responsibilities under the current calculation methodology. As such, I am confident that the system we have in place now would have allowed for a BBSW rate set even during the most challenging times of market liquidity – in other words, the global financial crisis.”