The various options that could be used for RFRs in cash market products are set out below. (For a detailed explanation of the various options for using RFRs as base interest rates, see the Financial Stability Board publication: “Overnight Risk Free Rates: A User’s Guide” (FSB Guide)). The derivatives market based on RFRs uses an “in arrear” structure. Cash market issuances based on RFRs currently also use an in arrear structure.
In this case, the base rate is calculated using historical rates and accrued interest is paid in arrear. There are then two alternatives as to how the interest rate for the relevant period is calculated:
- Simple interest is the easiest from an operational perspective. The relevant base rate is calculated using the simple arithmetic mean of the daily RFRs over the relevant period.
- Compound interest recognises that interest owed per day is calculated by applying the daily rate of interest to the total sum of the principal borrowed and the accumulated unpaid interest. Using this convention, there is equivalence between the compounded rate of interest and the interest applicable for a deposit that is held daily for the same period, i.e. it more accurately reflects the time value of money than taking a simple average. This method also aligns with the established market practice for calculating SONIA referencing derivatives, including OIS: which is likely to be preferable for hedging purposes.
Mechanism for in arrear interest calculation in an RFR product
As the parties to a finance contract will require some advance notice in order to be able to calculate and organise payments, there needs to be a time period to allow a final determination of the interest payable and to allow a degree of cash flow certainty before an interest payment is actually due. There are various alternatives to achieve this.
One approach is the ‘lag approach’. Here the payment date for interest lags behind the RFR calculation period by a period of time (e.g. say 5 banking days) in order to provide more time for the borrower’s operational cash flow management. There are two different types of lag approach:
- “payment delay” where interest is calculated and payable a set period of time after the end of the relevant calculation period;
- “lookback” where the observation period (or the period over which the reference rate is determined) commences in advance, a set period of time before the start of the interest period and ends on a date equal to that same period of time before the interest payment date.
Within the “lookback approach” there are two different alternatives:
- “lookback without observation shift” where the reference rate is derived from the observation period but weighted according to the days in the interest period;
- “lookback with observation shift” where the reference rate is weighted according to the days in the observation period (rather than the interest period).
Both alternatives will give broadly the same result, the main difference relates to how non-business days are treated. In both methods, a multiplier is applied to RFRs that fall on the day before non-business days. Essentially the lookback with observation shift method applies the multiplier to the RFR on the last day before the non-business day in the observation period. The lookback without observation shift applies to the multiplier to the reference rate for the day if the day (using a lookback period of 5 business days) that is five business days later is followed by one or more non-business days.
The Sterling Working Group has recommended (see here) that cash markets use the lookback without observation shift method but acknowledge that the lookback with observation shift is a robust alternative (See further – Current Transition to Risk Free Reference Rates).
The alternative approach is a ‘lockout’ or ‘suspension’ period. In this option, the RFR is no longer updated for a certain number of days prior to the end of an interest period (the ‘lockout period’). Instead, the rate for the day prior to the start of the lockout period is applied for the rest of the interest period. Consequently, the RFR for the interest period can be calculated a few days before the end of the interest period.
The Sterling Working Group has set out some considerations as to whether a lag or lockout mechanism would be preferable for market participants:
- A lag mechanism provides certainty at any point during the interest period whereas a lock out mechanism would only do so at the end of the interest period. Consequently, market participants may find a lag helpful in circumstances where there is a need to calculate interest accruing during an interest period, e.g. in circumstances of prepayment.
- Implementation of a lock out would require the additional functionality to lock the rate and then compound/average it and as such a lag mechanism may be simpler from an operational and systems perspective.
- A lag mechanism avoids the risk of locking the rate on a date where the rate is unusually high/low (for example, at quarter and year ends) which could lead to disproportionate changes in the underlying interest rate.
It can be possible to set base rates in advance, so that interest payments are already known at the start of the interest period, as in the case of IBOR based products. The “in advance” options have not been taken up by a significant number of market participants yet but are of two types:
- Last period: interest payments are determined on the basis of the averaged RFR of the previous period. A set mark-up can be added to the averaged RFR so as to ensure that the present value of this option is equivalent to an in arrear mechanism. In the case of a decreasing yield curve, this mark up would be negative. Alternatively, the mark-up could be seen as the price a borrower is willing to pay due to its preference to know and manage for the next interest payment in advance.1
- Last recent: here a single RFR or an averaged RFR for a short number of days, is applied for the entire interest period.
1 FSB Guide – see https://www.fsb.org/2019/06/overnight-risk-free-rates-a-users-guide/