For the better half of this decade, one could not help but hear and acknowledge the growing phenomenon of Financial Benchmark Reforms - an aftermath of manipulation and false reporting of global interest rate benchmarks. From the Wheatley Review in 2008 to the latest European Benchmark Regulation, regulators, administrators and market participants are engaging actively to restore investor confidence into the tainted benchmarks. Much of this work is in line with the Financial Stability Board’s (FSB) recommendations on reforming the interest rate benchmarks through a multi-rate approach.
There are two distinct parts to the multi-rate approach:
Strengthening existing and potential benchmark rates by underpinning them to the greatest extent possible with transaction data, and
Developing an alternative, nearly risk free, reference rates (RFRs) to encourage market choice
While the Financial Conduct Authority (FCA), in UK, is overseeing the reform of LIBOR, the Bank of England (The Bank) has been working to develop a nearly risk-free sterling reference rate as a robust alternative to LIBOR, particularly for use in sterling interest rate swaps. This stems from the fact that many users of derivatives prefer RFRs sans the term funding costs of banks factored into benchmarks like LIBOR.
Taming the Behemoth
The task at hand, for the Bank, is a complex one and requires a compelling proposition for the market to adopt, which in the words of Chris Salmon - Bank of England, requires collective effort to change market practice. It is in the light of this that the Working Group, tasked with the identification of alternative sterling RFR, has been weighing multiple options in line with the initial selection criteria.
This selection criteria includes availability of sufficient and reliable underlying market data, robustness to change in market structure, appropriate controls and governance, proxy to actual funding rates, potential end-user demand for linked products, ease of market adoption and consistency with similar RFRs in other international markets.
Underlying the aforementioned criteria, the Working Group’s focus is on first two of the four potential categories that the RFRs can be slotted into - Overnight Unsecured, Overnight Secured, Bank Rate and Other.
Overnight Unsecured: With the recently announced movement of administration under the auspices of the Central Bank, coupled with the reform roadmap such as inclusion of bilaterally negotiated as well as brokered transactions, Sterling Overnight Index Average (SONIA) is a preferred candidate for RFR. As SONIA is an established reference rate in OIS (with £4 trillion in notional value of outstanding contracts), the implementation could be straight forward. This, however, is dependant on seamless replacement of a Reformed SONIA since the rate in its current form with limited base and corresponding market volume may not pass the selection criteria.
Overnight Secured: A secured benchmark has the potential for a broader transaction base and could prove more robust in the long term. The consideration for such a benchmark would call for a more intricate analysis. The case of Repurchase Overnight Index Average (RONIA) has been tagged as ineffective in its current form as its represents only a small sub-segment of gilt repo market with insufficient volumes to support a robust fixing. It is therefore deemed necessary that an alternative rate be developed which satisfies the pre-determined selection criteria. Such potential alternative secured rates are in development by different firms currently and may need evaluation before final adoption.
This begets the question, which is a better candidate of the two? The choice is dependent on a number of factors such as viability, potential for market adoption, individual characteristics and more importantly the balance between ease of implementation and depth of the market.
Adoption Strategy and Transitional Arrangements
The preferred adoption strategy proposed by the Working Group involves a two-stage approach - (i) Establishing the selected RFR as the standard reference rate in the sterling OIS market in lieu of existing SONIA (ii) As the new rate gains traction with high activity and liquidity at the short end of the yield curve, encouraging the adoption of RFR across the gamut of yield curve. This approach is underpinned by the belief that a rate established as OIS reference and is used as the standard discount curve could ease the adoption the process.
As regards the transition strategy, two possible scenarios are under review - gradual or big-bang approach. While both the approaches have their respective pros and cons, the former seems more cumbersome with clearing eligibility issues and the risk of fragmented liquidity between current OIS and the RFR OIS markets. The big-bang approach could be a viable alternative involving a planned switch-over to the new regime for new and legacy contracts. However, it is important that the process chosen by the Bank is market driven to ensure a smooth transition.
It is evident that the overall direction taken by regulators is in line with the objectives of maintaining market buoyancy and restoring investor confidence. However, it is essential to ponder upon the fundamental questions regarding viability and adoption of alternative rates - especially in the light of renewed and focussed efforts of regulators, administrators and panel banks on the already established and seemingly indispensable benchmarks such as LIBOR. There are also the challenges of potential market inertia, potential legal constraints for international adoption and associated adoption costs during the transition.
From a financial institutional perspective, the introduction of new RFRs would mean strategic and operational changes to system, process, and governance frameworks across the board. Also, multiple reference rates and the corresponding multiple regulations accompanying them will result in an upward shift of overall compliance costs. These institutions have to be cautious and proactive in communicating to the customers any possible changes to the product portfolio resulting from the RFRs.
Though multiple steps are being planned and implemented by the regulator to ensure benchmark robustness and future continuity, there is no denying the impact of possible cessation or material alteration of benchmarks on markets. It is as critical for all the stakeholders to ensure that the selected benchmark is robust, reliable and future-proof as is the contingency plan.
We may have come a long way from the shadows of post-crisis era, but suffices to say that, we are just getting started.