Interest Rates regime benchmarks

Understanding the New Interest Rate Benchmark Regime — Part I

Ameya Abhyankar


This article is the first amongst a series of articles that I plan to write over the next few weeks to discuss the new interest rate benchmarks regime that is set to debut in the year 2021.

We often hear the term benchmark in our everyday lives. Benchmark is perceived as a standard or a reference marker in its respective field of application. For instance, a few commonly used benchmarks that come to my mind are:

a. Consumer Price Index (CPI): This is the reference for the current level of inflation in the economy.

b. Brent Crude benchmark: Based on the type of crude oil, there are benchmarks set for each of the types. These respective benchmarks act as a reference for the crude oil prices.

c. Interest rate benchmarks: There are a host of interest rates that get quoted in the market. Each of these rates serves a specific purpose. A simple example is the benchmark sovereign yield curve. Generally, this corresponds to the yield quoted on a sovereign bond with maturity of 10Y. This rate sets the tone for other associated rates in the economy. Another example are the Libor rates that get quoted in the market and which acts as a reference rate for various financial products trading in the market.

Each of the above benchmarks are designed to meet specific requirements of the market. Investors keep an eye on such benchmarks because they have an impact on their portfolios, whereas Regulators keep track of such benchmarks to aid in policy decision making which defines the course of the economy.

In this post, we begin with discussing history of interest rate benchmarks, the problems that are observed in the existing set of benchmarks, why benchmark rates are so important and finally talk briefly about the approach for the new benchmark regime.

Benchmarks — How they have traveled historically

In the mid to late 90s, US treasury bill rates (also referred to “T-bill”) were used as benchmark rates for various financial transactions. Up until the year 1986, the market was using these T-bills as a proxy for the rates in the market. However, there was a growing sense of motivation amongst market participants to shift from risk free rates like the T-bill rate, towards a new rates regime which would be a representative of the borrowing and lending costs in the market. This new rate was expected to capture the credit risk embedded in financial transactions, thereby giving banks a clearer picture of the interest rates prevailing in the market. This requirement of the banks and other market participants led to the transitioning of benchmark regime from T-bills onto a new regime governed by the interbank offered rates (also referred to as “IBORs”).

IBORs were considered as a good alternative owing to the fact that they were closely linked with the lending/borrowing rates by banks which is in turn a function of the asset-liability management framework of banks. The transition to IBORs happened around the year 1986 when the British Bankers Association (also referred to as “BBA”) started publishing IBOR rates on a daily basis. BBA used to collect interest rate quotes from a panel of large banks who were extremely active in the interbank segment, these rates used to be collated and published daily in the morning for the consumption by market participants. The BBA published IBOR rates for various currencies across multiple time tenors. BBA continued with the activity of publishing IBORs up until year 2014.

In the year 2012, a massive rate-rigging scandal involving IBORs was unearthed which shook the entire market. It was observed that the published IBORs were not really a fair representation of rates prevailing in the market. The daily IBOR quotes as provided by the participating banks did not depict the fair interest rate scenario anymore. As a result, IBORs lost a significant amount of their credibility in the market. Subsequent to the rates rigging scandal, the Financial Conduct Authority (FCA) performed an in-depth review of the entire process for IBORs and via their findings came up with a series of reforms for the IBOR benchmarks. These reforms were published in late 2012. Post this, the responsibility of publishing IBOR rates was handed over to an organization called Intercontinental Exchange (ICE). ICE publishes IBOR rates on a daily basis which are relied upon by market participants globally.

Why all the fuss — why are IBORs so important?

IBORs have been used extensively by market participants ever since their introduction in late 90s. IBORs are used as reference rates for financial products amounting to trillions of dollars globally. Almost, every major bank and host of market participants including hedge funds, insurance companies, corporates have a large portion of their financial portfolio that is dependent on the published IBOR rates. Thus, the sanctity of IBOR rates is of paramount importance in order to get a correct valuation of their portfolio of financial products. IBORs impact financial product valuations, which in turn have a bearing on the various other factors including capital adequacy computation by banks, collateral allocations by market participants etc. These are just a few reasons why IBORs are so important and this explains why every market participant is talking about the current state of IBOR and contemplating the future path for benchmark rates.

Market awaits a regime shift in benchmark rates — again!

Considering the problems being faced by IBORs, there has been a significant amount of work done by regulators and market participants to develop a new framework for benchmark interest rates. Most major markets globally have begun publishing a set of overnight rates (O/N). Such overnight rates may be considered as a proxy for risk free rates prevailing in the market. Thus, the push has been on building a set of O/N rates which are closely linked to the rates in the money markets. The idea is to have a set of rates derived from the actual transactions happening in the market. At present, the liquidity of products linked to the new set of risk-free rates is low, however, gradually, the liquidity is expected to increase as the volume of trades increases. Thus, in late 90s the market had transitioned from risk free T-bills benchmark onto IBORs and now again it would be switching back to a risk-free rate as a benchmark. A few major markets globally are contemplating having a two-benchmark approach, wherein the existing benchmark would continue to exist, and this would be complemented by the new benchmark regime. The transition to a new regime is seen by many as an overhaul of the global financial system. The main concern that remains is a smooth transition into the new regime.

In the next post, we will further explore the intricacies involved in the transition into the new benchmark regime.


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