Understanding the New Interest Rate Benchmark Regime — Part III
This article is the third and the final article amongst a series of articles that I have published to discuss the new interest rate benchmarks regime that is set to debut in the year 2021. The previous two articles of this series can be found at the following:
In this post, we begin by looking at a few floating rate benchmarks that are expected to be at the center of the new interest rate regime. Then we will explore key characteristics of overnight rates. Subsequently, we will discuss the pros and cons of the two-benchmark approach and conclude with discussing the impact on certain local benchmarks that are dependent on the existing framework.
Meet the new floating rate benchmarks
A few key benchmarks which are identified as alternatives to the existing IBOR benchmarks are enlisted below:
a. Secured Overnight Financing Rate (SOFR) — United States
b. Sterling Overnight Index Average (SONIA) — United Kingdom
c. Euro short term rate (ESTER) — Eurozone
d. Swiss Average Overnight Rate (SARON) — Switzerland
e. Tokyo Overnight Average Rate (TONA) — Japan
The above benchmarks correspond to the five largest currency areas. A few key points pertaining to above rates are:
— All are overnight rates
— All rates are available for consumption by the market
— All rates with the exception of SARON, include trades with non-bank counterparties
— SOFR and SARON are based on secured transactions in the market i.e. repo transactions in the market. Other benchmarks allow unsecured transactions.
Characteristics observed for the new overnight rates
a. Higher volume of traded rates:
The advantage of usage of overnight rates is the volume of transactions. The volumes are high which supports the theory of transition to these new benchmarks. Regulators and market participants had embarked on the journey of forming a new benchmarks regime with the very idea of capturing actual traded rates as the benchmarks, and these new benchmarks meet this requirement.
Further, the inclusion of transactions with non-bank counterparties, has given a fillip to the traded volumes in the market. This liquidity in the market offers the opportunity to efficiently derive benchmark rates which are firmly grounded in the market
b. Movements in sync with the policy rates:
It is observed that the movements in the new overnight rates are tracking the policy rates to a considerable degree of satisfaction of the market. This provides a very optimistic picture to monetary authorities globally because the policy decisions made by these monetary authorities will get reflected in the new overnight rate benchmarks. This will provide regulators with a mechanism to monitor the degree to which their policy decisions on interest rates are transmitted to the market.
c. Taking into account the inclusion of non-bank transactions:
The inclusion of trades from non-bank counterparties are expected to impact the way new overnight rates behave vis-à-vis policy rates. It is expected that the inclusion of such trades may result in the new overnight rates exhibiting a certain spread over the policy rates. In normal market conditions, this spread is not expected to exhibit significant volatility. This spread in rates may be explained by the fact that non-bank counter-parties do not have access to the central bank deposit facilities i.e. repo transactions with the central bank.
d. Volatility due to conditions in the collateral markets:
Rates like the SOFR and SARON are based on secured (i.e. repo) transactions. Repo is defined as a transaction where one party (say Party A) pledges securities as a collateral (called as collateral leg) to another party (say Party B) in exchange for cash (called the cash leg), and with the promise to re-purchase those securities at a higher price at a certain time in the future. The reason behind re-purchasing at a higher price is to account for the interest rate involved in borrowing funds for that particular duration of time.
There are times when market confidence gets jittery owing to certain events in the market, this causes a spike in demand for securities collateral (which are mainly treasury/sovereign securities) on such repo transactions. This is because treasury securities are risk free in nature, and thus their demand rises in times of distress (i.e. the collateral leg gets more expensive than the cash leg). This may result in some divergence between the overnight rates and treasury rates.
There may also be times when there is excess supply of treasury securities in the market owing to a treasury auction by the central bank. In case, if market participants are already holding a significant amount of treasuries on their books and won’t purchase additional treasuries (i.e. the demand for collateral leg falls and cash leg rises, thus, the cash leg gets more expensive than the collateral leg). Thus, supply and demand conditions from the funding side as well as from collateral side may exhibit periods of volatilities.
Moving towards the “two-benchmark” approach:
Most jurisdictions globally are contemplating towards using a two-benchmark approach. This will involve using the new benchmark rates, at the same time continue to use the existing IBORs albeit with a few modifications. Thus, there would be two sets of rates that would co-exist at any point in time. For example, in the Eurozone, the reformed EURIBOR would co-exist with ESTER. A lot of research is being carried out by the industry as well as academia in order to arrive at a methodology for computing the reformed term benchmark rates. The aforesaid methodology is still a work in progress and the industry participants are trying to arrive at the most appropriate methodology that could be adopted by the market in the future.
Multiple benchmarks: a boon or a bane?!
Different approaches to devise methodologies to be applied to calculate the reformed credit sensitive benchmark is expected to bring market segmentation. Also, too many reference rates would swarm the market. Whereas, some market participants may be able to tackle such issues, other less savvy market participants may find it difficult to adjust to the new framework at least in the near to medium term.
However, on the flip side, there could also be potential advantages of having multiple benchmarks which will allow market participants to apply respective benchmarks for specific purposes. This is something which was not possible earlier when there was just one benchmark curve in the market.
What about the economies whose local benchmarks depend on existing IBORs?
There are many economies which are dependent on existing IBORs and FX-swaps market. For instance, in India, the MIFOR curve is widely used as a reference rate for swaps contracts. MIFOR is derived from USD LIBOR with an adjustment of premium points derived from the FX market. With the existing IBORs getting reformed, these will directly impact such local benchmark rates. Market participants are trying to gauge the degree of this impact and also formulate possible solutions to address such impending issues.
Thus, we can conclude that the interest rate benchmark reform process promises a vast set of challenges which the market is attempting to foresee. Central banks, industry participants and academicians are all working together to devise plans to minimize disruptions in the financial system when the new benchmarks are introduced to the existing rates framework. All said, this is a much- awaited reform in the financial industry and is expected to enhance credibility of benchmark rates which will boost market perception towards the new benchmarks framework.
image source: www.investopedia.com
BIS quarterly review, 2019 March