Base camp

The global derivatives community gathered in Hong Kong in April for the International Swaps and Derivatives Association (ISDA) AGM, with interbank offered rate (IBOR) transition top of the agenda. Progress towards a new market paradigm continues to be made but the scale of a task in which cash markets have a key part to play cannot be underestimated.

Laurence Davison Head of Content and Editor KANGANEWS

It is now widely known and understood across markets that from the start of 2022 – earlier in some jurisdictions – banks will not be compelled to submit rates for IBOR calculation and, as a result, many benchmarks are widely expected to become defunct. The consequences will be wide-ranging and, crucially, will affect market participants well beyond the group that is currently deeply engaged with the first-order impact.

The steps that need to be taken to reach resolution are relatively well understood. In general, speakers at the ISDA event expressed satisfaction with progress to date. But they also suggested that global markets have really only just begun what will inevitably be a long and complex journey.

The first step – the nomination and development of alternative risk-free rates (RFRs) to replace IBORs – is complete in most jurisdictions. There has also been progress towards adoption of RFRs as benchmarks in cash and derivatives markets, in particular in the UK and, to a somewhat lesser extent, the US.

However, even in these countries progress has really only started to scratch the surface of what needs to be done to transition to a post-IBOR world. Notably, depth and tenor remain works in progress in the derivatives space while RFR adoption in cash bond markets is, as yet, relatively narrow and has yet to reach the corporate sector in any meaningful sense.

There has been decent growth in SONIA-linked bond issuance, predominantly by banks – especially covered bonds – and SSAs. I’m sure this will grow and I expect to see a broader issuer base in 2019. But I think it will be a while before it spreads to corporates.

UK and US lead

The UK is the acknowledged global leader in IBOR transition, assisted by the established nature of its RFR. The US is also progressing fast even though its nominated RFR is a relative newcomer.

The UK has two major leg-ups when it comes to replacing LIBOR. The greatest is the fact that its nominated RFR, the sterling overnight index average (SONIA), is long-established and relatively well used especially for short-dated swaps. The second lies in the adoption benefits that come from being a historically long-dated cash market.

Adoption of SONIA as the benchmark for floating-rate note (FRN) coupons in the UK continues apace. Market participants estimate around half of issuance so far in 2019 has been priced off the new reference rate rather than LIBOR.

At the same time, depth has started to develop in the crucial long-dated SONIA swap market. David Horner, head of risk and rates derivatives at LCH, told the ISDA AGM that around 20 per cent of long-dated sterling swaps now use SONIA as their reference rate, or roughly twice the level from just a year ago.

“Even taking into account the volume of trades already outstanding in the SONIA market, I think the progress of the long-dated swap market can be described as a qualified success story,” Horner added. “Half the interbank swap market is now based on SONIA rather than LIBOR, for instance.”

This is where the long-dated nature of the UK market helps. A pension system that retains a significant defined-benefit component has propagated a market with a proliferation of liability-driven investment (LDI) managers. These funds have a natural desire for liquid, long-dated swaps and have thus helped support IBOR transition.

“The UK is a very long-dated market, which meant that when discounting risk became a topic of interest there was already plenty of long-end exposure to OIS [overnight indexed swap],” explained Nat Tyce, managing director and head of macro trading, EMEA at Barclays. “For instance, some of the most active long-dated market participants are LDI managers.”

The US, meanwhile, is starting from scratch with its own RFR. Horner explained: “SOFR [secured overnight funding rate] is a much more difficult task than SONIA – it didn’t exist at the start of last year and swaps only started trading in July 2018. As a further complicating factor, there is also a well-established OIS rate in the US in the form of Fed funds, which effectively acts as a competitor for SOFR.”

The existence of the Fed funds rate has sparked some negativity when it comes to the acceptance of SOFR as the nominated RFR in the US. However, Horner argued that clear regulatory support for SOFR suggests that it will prevail.

There are already positive signs for SOFR in the cash market. While issuance based on the rate is not as widespread as it is in the UK, entities that have issued SOFR-linked notes say they have had relatively positive experiences.

One such is MetLife, which printed a US$2 billion, two-year floating-rate benchmark using SOFR in August 2018 – the first such transaction to come from an issuer outside the supranational, sovereign and agency (SSA) sector. “I actually thought takeup on this deal was better than what we had experienced in recent LIBOR-linked FRNs with similar tenor,” suggested Jason Manske, EVP, senior managing director, chief hedging officer and head of derivatives liquid markets at MetLife.

US derivatives-market evolution is perhaps a step further back when it comes to RFRs. “Far from ‘getting there’, the cumulative volume in SOFR swaps to date is about the same as an average morning in the LIBOR market,” Horner admitted. “But we knew it would be a long process and actually I am quite happy with the progress we have seen so far.”

Far from ‘getting there’, the cumulative volume in SOFR swaps to date is about the same as an average morning in the LIBOR market. But we knew it would be a long process and actually I am quite happy with the progress we have seen so far.

Transition issues

On a narrow basis, market users say managing the transition to products using RFRs is not inherently problematic. MetLife is also an investor, and Manske revealed that the firm has purchased SOFR-linked FRNs from government-sponsored enterprises. It has, he added, been relatively easy to book transactions using a simple average SOFR rate – in fact MetLife was able to configure its systems to do so overnight.

This is not the end of the story, though. For instance, Manske continued: “It’s harder in the derivatives space because we need hedge accounting to do SOFR derivatives. We have had to delay plans to go live with SOFR derivatives but we hope to be able to do so – from an operational and technological perspective – in the coming months.”

Even more relevant to the bond market is the mismatch between RFRs in their basic form and the type of coupons fixed-income issuers and investors are used to. Specifically, RFRs do not inherently include any element of credit risk or term. IBORs, by their nature, reflected a bank credit premium over a time period, generally of 30-180 days.

“Borrowers prefer to know their interest rate at the start of an accrual period,” said Cadwalader, Wickersham and Taft partner, Lary Stromfeld. “Contract fallback language in the US has forward-looking compounded SOFR as its first option on LIBOR cessation and it’s clear that this is the most desirable option. The problem is that it doesn’t exist.”

The issue of recreating a proxy term and credit component to add to RFRs – and thus make them a more direct parallel with IBORs – can be resolved, market users believe. ISDA has made significant steps towards offering something it believes should fit the bill.

According to Anne Battle, ISDA’s deputy general counsel, the proposed adjustment for credit will be based on a historical mean of IBOR versus the risk-free rate. This will reference a vendor, so there will be screen pricing for the credit adjustment and the formulae for its calculation will be public just as market users can see IBORs on screen today. ISDA is undertaking an RFP to select this vendor and hopes its approach will offer the market certainty.

Breadth of takeup

The biggest issue markets may face is that all sectors into which IBORs have extended their influence are not equally engaged with transition as the market leaders. This already appears to be playing out in the UK, where the LDI sector has supported the interbank market in catalysing early transitional progress but wider adoption of SONIA issuance and hedging remains a work in progress.

Tyce revealed that even banks – which are among the most active users of the long-dated SONIA swap market to date – are not particularly active when it comes to swapping long-dated debt issuance to SONIA format.

In this case there may be an operational, or more precisely a regulatory, hurdle. Laura Lise, head of traded risk analytics, Asia Pacific at HSBC, explained: “RFRs don’t qualify for internal models on capital under Basel III and in the fundamental review of the trading book environment, because there is not yet enough historical data or market liquidity. These products will therefore have to be quite heavily capitalised, which is inevitably an impediment to liquidity on the bank side.”

Adoption is even thinner beyond the boundaries of the interbank and specialist-investor space – even in the UK. Real-money and hedge-fund investors have largely remained on the sidelines to date, Tyce added, while there has been minimal activity from the corporate sector.

Broader takeup will be needed for a successful transition to be achieved, Horner argued. “Lots of things need to be updated and upgraded and this needs to happen across the market. It’s no use if the clearinghouses are the only ones that can handle these products – there has to be an active market for SOFR-based deals and subsequently for derivatives. If issuance comes, the need for hedging and thus derivatives will be inevitable.”

The warning note many market participants are sounding is that while progress towards IBOR transition has been strong it has so far largely been limited to entities with a natural interest in the issues at stake. To complete the process successfully, understanding of those issues and willingness to respond will need to permeate further into the financial sector’s hinterland.

“The biggest challenge in cash markets is education,” Stromfeld argued. “How can we change the contractual basis of loans for corporate and even retail customers when we are still discussing how to do so in an institutional market that uses standardised documents?”

The further reaches into which IBORs’ influence has permeated will inevitably pose unique challenges. Stromfeld suggested that bilateral loans, by their nature, are easier to amend – they pose an operational challenge but ultimately a lender can sit down with its customer and discuss the need to revise a contract.

“It’s not the same for capital-markets transactions,” he added. “If you want to amend a transaction generically, let alone something like changing the interest rate that gets paid, you generally need the consent of 100 per cent of investors.”

When this discussion started I used to use the phrase ‘basis risk’ as a warning. I think we have come around to accepting that basis risk is going to happen, and that it will be a new type of risk – but we have got used to managing these.

Grounds for optimism

A potentially positive catalyst is the side issue – albeit a massively important one – of the future of contracts written in a world that assumed IBORs would continue to exist indefinitely but which will still be outstanding beyond the likely lifespan of these benchmarks.

Agreeing – and then implementing – common fallback language will be necessary, and some market users believe this will provide the spark of engagement. Horner explained: “If they want to be responsible in managing contracts, market participants had better have systems in place to manage SOFR contracts if LIBOR is not available. That means having SOFR systems in place, full stop – and this might be the catalyst for market transition.”

Within this hope lies yet another financial-market chicken-and-egg dilemma. “The goal should be for market participants to transition to risk-free rates themselves, with fallbacks being very much plan B. The problem is that we don’t currently have sufficient liquidity in the RFRs to prompt the transition,” said Linklaters partner, Deepak Sitlani.

The roadmap drawn by derivatives-market participants relies on the hedging and markets world being ready for the wider financial community when the fullest range of entities address the ways in which IBOR transition will affect them specifically. Transactional activity and thus liquidity should follow this larger group.

This will inevitably take time. Tyce suggested: “There has been decent growth in SONIA-linked bond issuance, predominantly by banks – especially covered bonds – and SSAs. I’m sure this will grow and I expect to see a broader issuer base in 2019. But I think it will be a while before it spreads to corporates.”

Plenty of market participants are ready to follow liquidity, which should create a snowball effect when there is critical mass of activity in RFRs and related cash and derivatives markets.

Tyce continued: “The bulk of real-money and hedge-fund activity is still in LIBOR but there seems to be a good degree of confidence in SONIA and I expect the change to be quite quick when it occurs – this sector will go where the liquidity is. We are already seeing some accounts actively trading the basis where they see an arbitrage opportunity.”

Conceptually, most speakers at the ISDA event appear to be confident that IBOR transition will in time deliver a market with different risk characteristics but which remains functional for all users.

Jack Hattern, managing director, global fixed income at BlackRock and an ISDA board member, said: “When this discussion started I used to use the phrase ‘basis risk’ as a warning. I think we have come around to accepting that basis risk is going to happen, and that it will be a new type of risk – but we have got used to managing these.”