Understanding the New Interest Rate Benchmark Regime — Part II

This article is the second amongst a series of articles that I plan to publish over the next few weeks to discuss the new interest rate benchmarks regime that is set to debut in the year 2021. The first article of this series can be accessed at: Part I of this article

In this post, we begin with discussing the desirable properties of a good benchmark rate, we will then compare the properties of existing IBOR rates vis-à-vis the aforesaid desirable properties. Further, we will discuss the motivation to transition away from Libor, and, subsequently talk briefly about the way markets are adopting the new benchmarks regime.

Why can’t IBORs be called risk free rates?

What qualities make up for a good benchmark?

Provide a reference rate for longer term contracts: There are many financial contracts in the market that extend well beyond the money markets (i.e. more than 1 year). The benchmark rate should be able to provide reference rates to such longer tenors of contracts. A common example of such contract is an overnight interest rate swap (OIS swap). OIS rates have their underpinnings in the O/N rates in the market.

Correct representative of rates prevailing in the money markets: Benchmark rates that are based on the actual traded rates in the money market depict a true picture of the rates prevailing in the market. As a result, rigging of such rates becomes impossible, thereby enhancing the robustness and credibility of the benchmark for usage of market participants.

Provide reference to lending/borrowing by market participants: A good benchmark enables banks to efficiently manage their asset-liability position. For asset-liability management, banks focus on their marginal cost of funding. Banks often approach the market for satisfying their borrowing requirements. These requirements may stem from various reasons like meeting capital adequacy, managing the gap in their asset-liability book etc. An availability of a good benchmark helps banks assess the marginal cost of funds helping them to manage their asset-liability book in a better way.

Do IBORs carry the qualities of a good benchmark?

Firstly, IBORs provide a good reference rate for longer term transactions. In the market, we have IBOR based swaps extending to tenors generally up to say 10 years. There are albeit few swap trades that extend to longer maturities ranging beyond 10 years. IBORs satisfy the requirement of providing the floating leg benchmark for such trades.

Secondly, IBORs relate with the cost of funds for a bank. Cost of funding is an important quantity that impacts the bank’s asset-liability book.

Thirdly, IBORs have been recognized and are well accepted by the market participants making them a good reference rate.

However, there are a few shortcomings in IBORs which we will discuss in the section below where we talk about the points that have motivated market participants to transition away from IBORs.

Motivation to move away from IBORs!

Another point of concern is the volume of trades in the interbank deposits market that has been gradually decreasing over time. This decreasing trade volume impedes the process of discovery of the true interest rate levels in that market. One of the reasons for this may be that banks are charging a premium on the rates, to account for the credit risk that comes from trading with other banks. This would result in a pushing up the cost of funds for the borrowing bank which would finally result in an impact on its profit margins. Thus, over the last few years, there has been a growing trend with banks trading with non-banks (may be say corporates) to meet their funding needs. This trend has seen a gradual up-stick in terms of volumes. This can be considered as an advantage because these rates will be from actual trades that are happening in the money market. Rates which are a function of actual trades in the market are a true representative of the interest rate levels. The more the volume of actual trades in the market, the better does it suit the purpose of arriving at the true lending/borrowing rates.

Further, the derivatives market is no stranger to the term dual curve discounting. For example, for pricing a plain vanilla interest rate swap which is a popular derivative trade, market participants use OIS i.e. Overnight Indexed Swap rates curve for the purpose of discounting cash flows to calculate the current price (i.e. also called as the mark-to-market) of this product. OIS rates are derived from the O/N rates that are quoted in the money markets. O/N rates are in turn based on actual traded rates which makes them highly appealing to market participants and regulators alike. Therefore, it would not be incorrect to say that the derivatives market has already been following the process of using money markets rates i.e. funding rates in their product pricing for quite some time now. This is good news because it is in sync with the market requirement of gradually using overnight rates for most of its applications.

Introducing the new reference rates regime to the market

In the next article of this series, we will talk a bit more about the new floating benchmarks, their qualities and much more!

References:

www.bis.com

image source: www.investopedia.com

BIS quarterly review, 2019 March

Founder: FinQuest Institute; www.finquestinstitute.com