Risk free reference rates (RFRS) - comparison with IBORs
RFRs are not new benchmarks. They measure secured or unsecured overnight borrowing costs in the financial markets. SONIA (Sterling Overnight Index Average) and similar reference rates are described as (near) risk-free because the overnight transactions that make up the underlying data reflect nominal or minimal credit risk.
RFRs are a very different animal from IBOR and the other IBORs that have been predominantly used in the corporate bond, loan and derivative markets. The main differences are:
- IBORs are forward looking rates and set for terms which match typical interest periods for financial products (e.g. one, three, six, and twelve months), and can be ascertained at the beginning of an interest period, allowing determination of the amount of interest payable in advance. RFRs are backward looking overnight rates.
- IBORs are created from a survey of a small set of banks reporting non-binding quotes. These quotes are based on limited activity in the interbank lending market and it is argued that limited real transactions underpin the submissions for IBOR. RFRs on the other hand are meant to be built on the basis of real, verifiable transactions which should mean they are not open to manipulation.
- IBORs incorporate a risk premium (the rate taken into account that the interbank loan will be outstanding for the term rather than just overnight) or credit spread. As the name suggests, RFRs do not include any risk premium.
- IBORS are multi-functioning reference rates, capable of operating across products, markets and jurisdictions which, originally, facilitated the information of the financial markets. It is uncertain whether the proposed RFRs can replicate this feature.
Where are we now - IBOR?
Central banks have taken the lead on seeking suitable alternatives to IBOR. The Bank of England and the FCA established the Working Group on Sterling Risk-Free Reference Rates (the Sterling Working Group) which has recommended using the SONIA benchmark as the preferred RFR for Sterling markets.
In the United States, the Alternative Reference Rates Committee (the ARRC, comprised of a group of market participants convened by the Federal Reserve to identify an alternative USD reference rate for use primarily in derivative contracts) has recommended the Secured Overnight Funding Rate (SOFR) as an alternative to IBOR for pricing US Dollar denominated loans and derivatives transactions. SOFR is an overnight secured rate calculated based on transactions in the US Treasuries repurchase market.
In Europe, the Euro Working Group has recommended the €STR as the new euro risk free reference rate in place of EONIA. €STR is a short-term rate administered by the European Central Bank which reflects the wholesale euro unsecured overnight borrowing costs of banks in the euro area.
A significant challenge is for the relevant markets (primarily bonds, loans and derivatives) to move as quickly as possible to the new RFRs to try to reduce problematic transactions when IBOR ceases. Initially there was general market inertia, with market participants being reluctant to be the first mover, and market concerns about the mechanics of the proposed replacement rates, given RFRs do not present an easy alternative to the forward looking term rates the markets are accustomed to.
However, over the last few months, significant strides have been taken to settle on market conventions.
Another looming challenge for the market will be to amend and convert legacy contracts to provide for these new rates when IBOR ceases or becomes unrepresentative – which could occur during early 2021.
On 19 November 2019 the FCA published a statement and Q&A paper on conduct risk arising from IBOR transition which sets out the FCA’s expectations with regards to firms having a strategy in place, taking necessary action during the transition and ensuring that customers are treated fairly.
2020 Call for Action
In January 2020, the Sterling Working Group published a statement of its priorities and an updated roadmap for 2020 highlighting important events and clarifying action market participants should take to reduce IBOR exposure and transition to alternative rates, including:
- Ceasing issuance of cash products linked to sterling IBOR by the end of Q3 2020.
- Throughout 2020, taking steps to promote and enable increased use of compounded SONIA.
- Taking steps to enable a further shift of volumes from IBOR to SONIA in derivative markets.
- Establishing a framework for the transition of legacy IBOR products, in order to significantly reduce the number of IBOR-referencing contracts by Q1 2021.
- Considering how best to address the issues around ‘tough legacy’ contracts.
In addition the Sterling Working Group issued a paper (the Working Paper) firmly setting out its view that overnight SONIA compounded in arrear (SONIA CIA) should be the primary vehicle for IBOR transition, ahead of any prospective Term Sonia Reference Rate (TSRR).
At the end of February, the Bank of England published a discussion paper: Supporting Risk-Free Rate transition through the provision of compounded SONIA (the Discussion Paper) in which the Bank seeks views on the publishing of various SONIA calculations to ease the transition from IBOR to SONIA referenced products.
The Sterling Working Group has chosen SONIA as its recommended RFR and aims to facilitate a transition to SONIA by the end of 2021 across the Sterling derivative, bond and loan markets. It has set a target for the markets to cease issuing GBP IBOR-based cash products maturing beyond end 2021 by the end of Q1 2021. The Working Paper positively comments on the barriers and the work currently underway to address these such as updating of IT and treasury management systems, the LMA’s work on standardising documentation (see below further), and the gradual establishment of market conventions as new SONIA CIA loans are being executed in the market, albeit in limited pilot schemes and specific circumstances.
SONIA CIA v TSSR
SONIA is an overnight rate and calculated on backward looking basis. In order to use SONIA CIA to calculate interest over a longer period, the current preferred approach is to use SONIA compounded in arrear over a period that starts before the interest period and finishes before the interest payment date (the so called “lag approach”). The reason for the lag is to allow interest to be calculated prior to the end of the interest period, giving the borrower time to arrange payment due at the end of that period. A TSRR would be a forward-looking reference rate based on overnight SONIA, which would work operationally and in documentation in a similar way to IBOR. The Working Paper notes that FTSE Russell, ICE Benchmark Administration, Refinitiv and IHS Markit are each working on developing a TSRR, with a number of these products in beta testing.
However, the Sterling Working Group supports the UK authorities’ preference for a broad-based transition to SONIA CIA and advises that the use of a TSRR will only be appropriate for borrowers which cannot operate with an in arrear rate or where they have very simple needs. The Working Paper states confidently that use of SONIA CIA is “appropriate and is likely operationally achievable for approximately 90% by value of the Sterling IBOR loan market”. The Working Paper outlines the arguments for SONIA CIA as follows:
- it is more robust than a prospective TSRR;
- it will work more consistently with the derivatives markets and enable more effective and cost- efficient hedging;
- it will work more consistently and reliably across multiple markets; and
- term rates may not be available in all currencies, and SONIA CIA will work across multi-currency facilities.
As regards the remaining 10%, the Sterling Working Group expects these transactions would require fixed rates, Bank of England’s Bank Rate or a TSRR, but that these alternative rates will need be required for specific circumstances only, and notes that further consideration is necessary for trade and working capital facilities using discounted cash flows, Islamic finance, and project and real estate finance transactions.
The Working Paper called for firms to engage urgently on IBOR transition to SONIA CIA.
In February, the Sterling Working Group advised it was setting up three new task forces: (i) a Loan Flow Enablers Task Force focussing on enablers to moving new loans away from IBOR; (ii) Cash Market Legacy Transition Task Force looking at frameworks to support the transition of legacy cash products; and (iii) Tough Legacy Task Force to provide market input regarding the products that may prove unable to be converted or amended to include robust fallback.
Bank of England Discussion Paper – February 2020
In effectively an acknowledgment that the market infrastructure to support SONIA CIA as the main alternative to IBOR was not yet ready, the Bank of England published its Discussion Paper to assist in the acceleration of the adoption of SONIA as a reference rate in Sterling markets. It sought views on the publication of two indexes, a SONIA Compounded Index and a SONIA Period Average.
The Discussion Paper noted that although compounded SONIA is already established for use in the Overnight Index Swaps market and in the Sterling floating rate bond market (see also above), it required a number of data points to calculate that may not be easily available to corporate borrowers. As such, following a range of feedback given to the Bank, it was clear that market participants wanted a trusted calculation source against which rates published by other providers could be checked.
A SONIA Compounded Index would, in the Bank’s view, simplify the calculation of compounded interest rates by:
- making it easier to calculate compounded interest rates with only 2 data points required (compared to the 60 (one for each business day) needed to calculate SONIA CIA for a three-month interest period;
- creating a set of conventions that would reduce uncertainty and confusion amongst users around calculation methodologies; and
- providing flexibility to calculate SONIA CIA for any combination of start and end dates to a period.
The other proposal by the Bank was that it publish a simple set of compounded SONIA Period Averages in order to give market participants access to a SONIA interest rates compounded over a range of set time periods (e.g. 30 days or three months).
The SONIA Period Averages would provide further simplicity by publishing compounded rates that could be directly referenced in contracts. They would not cover every reference period used by market participants but in the interests of simplicity and utility, only be a limited set of periods of time.
Through the Discussion Paper, the Bank sought market consensus on the conventions to be applied for these period averages. Those conventions would require reaching consensus on an unambiguous start date for each day a period average was published and the annex to the Discussion Paper set out three alternatives that the Bank is proposing could apply:
- reference periods of exactly 30, 90 and 180 days;
- reference periods of exactly 1, 3 and 6 months; or
- reference periods of exactly 1, 3 and 6 months adjusted to start on a business day using the “modifying following” convention.
In June 2020 the Bank published a summary1 of the feedback received and its response to that feedback:
- the Bank confirmed it will publish a daily SONIA Compounded Index and anticipates to do so from 3rd August 2020;
- feedback was in support of the proposed methodologies for the SONIA Compounded Index (similar to SOFR), and noted the compatibility with the ‘observational shift’ convention, rather than observational lag;
- the feedback was mixed as regards “period averages” and the Bank has advised it does not propose to produce such “period averages”.
COVID – 19 Impact
The message from the regulators remains: 2020 is still a pivotal year in the transition journey, engagement on transition is strongly encouraged so that compounding conventions can be settled by the market. The Bank of England’s Financial Stability Report issued in May notes the continued importance of the continued transition from LIBOR, and the PRA and FCA resumed full supervisory engagement on Libor from 1 June 2020, including data reporting at the end of Q2. The regulators recognise the challenges presented by the operating environment in place as a result of the COVID 19 pandemic and consequently, the Sterling Working Group revised their recommendations for the loan markets to be:
- by the end of Q3 2020 lenders should be in a position to offer non-LIBOR linked products to their customers;
- after the end of Q3 2020 lenders, working with their borrowers, should include clear contractual arrangements in all new and re-financed LIBOR-referencing loan products to facilitate conversion ahead of end-2021, through pre-agreed conversion terms or an agreed process for renegotiations; and
- all new issuance of sterling LIBOR-referencing loan products that expire after the end of 2021 should cease by the end of Q1 2021.