Swaps Market Gained From Benchmark Reform

Shanny Basar

The UK Financial Conduct Authority said the addition of seven benchmarks to its regulatory regime were beneficial for already liquid markets and the swaps market also gained a more representative benchmark.

After the financial crisis there were a series of scandals regarding banks manipulating their submissions for setting benchmarks for their own benefit across asset classes, which led to a lack of confidence and threatened participation in the related markets.

The UK government then carried out a Fair and Effective Markets Review and as a result the FCA began regulating seven benchmarks in April 2015 – including the Sterling Overnight Index Average (Sonia) for interest rates and the ICE Swap Rate, formerly ISDAFIX.

The UK regulator has analysed transaction-level data of swap and foreign exchange markets and met 38 firms who either participate in the benchmark setting process or use regulated benchmarks for its report this week, Evaluation Paper 18/2: the impact of bringing additional benchmarks into the regulatory and supervisory regime.

The study concluded that changes to benchmark methodologies and increased supervision had a positive impact on robustness and reassuring users but the evidence on the underlying markets is mixed.

“Our findings suggest that the interventions were beneficial for already liquid markets,” said the FCA. “For less liquid markets, the perceived increase in regulatory risk may have contributed to a further reduction of the liquidity observed.”

The regulator highlighted there have been clear benefits in the swaps market as benchmark representativeness improved between 12% and 68% (depending on time interval) and liquidity increased by 11% to 14%.

“Stakeholders perceived Sonia as one of the most robust benchmarks in the market because it is based on traceable transactions,” added the FCA. “In their views, enormous trading volumes would be required to manipulate the benchmark.”

A reformed version of Sonia has been chosen by the Bank of England as the UK’s alternative to replace sterling Libor so that benchmarks are based on underlying transactions. The FCA has said it will not require banks to submit Libor beyond 2021. The Federal Reserve has identified the secured overnight financing rate (SOFR) as its preferred alternative for US dollar Libor, which is a secured overnight rate based on a much larger universe of repo transactions than in any other segment of the US money market.

Scott O’Malia, ISDA

Scott O’Malia, chief executive of derivatives trade association ISDA, has stressed that benchmark reform is the biggest task for the financial industry due to the large number of derivatives and loans which are pegged to Libor.

He said at ISDA’s regional conference in London last month: “In fact, I can’t think of any other event past or present that even comes close in terms of scale and impact.”

As a result the derivatives association launched a consultation in July regarding implement fallbacks for derivatives contracts referenced to certain interbank offered rates, for which comments are due this month.

Need to prepare

Daniel Mminele, deputy governor of the South African Reserve Bank, gave a speech in Cape Town yesterday about Libor reform.

“Given the lack of confidence in, and the declining credibility of, the major interest rate benchmarks after the Libor incidents became public in 2012, these initiatives culminated in recommendations on how to strengthen the key interbank offered rates (collectively referred to as ‘Ibors’) and use risk-free rates (RFRs) for derivative markets,” said Mminele. “This was also informed by the systemic nature of the risk that major interest rate benchmarks posed to the global financial system.”

He noted that the Alternative Reference Rate Committee in the US has published a report showing that while exposure to Libor has grown, the volume of transactions underlying Libor has been declining. The scarcity of underlying transactions has been viewed as problematic and has already resulted in increased conduct risk.

“Furthermore, as the ratio of underlying transactions to the gross notional value of financial contracts referencing Libor continues to dwindle, the risk that Libor will not be sustained over the long term increases,” he added. “From a policymaker’s perspective, this mismatch poses risks to the stability of the global financial system, especially given the systemic importance of Libor.”

Mminele stressed that there is a considerable amount of work to be done by market participants that have large exposures to Libor – especially if they have existing Libor exposures with maturities beyond 2021, and if alternative reference rates differ markedly from Libor.

“The year 2021 – the date towards which market participants seem to be converging in marking the end of Libor – may seem like a distant future, but the amount of preparatory work to be done leading up to that time will make it seem sooner than it seems at the moment,” he said. “While the timing of implementation might be uncertain, and while the plans might be fraught with complications, benchmark regulators are unlikely to reverse the decision to reform rates. It is therefore in the interest of all stakeholders to start positioning themselves for a new interest rate benchmark dispensation instead of adopting a wait-and-see approach.”

Related articles

  1. The paper proposes a path forward for standard SLD documentation.

  2. Exchange group’s crypto suite has had consistent volume and open interest growth.

  3. The derivatives venue owned by FTX wanted to offer products that were not fully collateralized.

  4. The proposed standard applies to the processing of give-ups and allocations.

  5. Basel Committee Consults on Interest-Rate Risk

    The launch is a milestone in establishing €STR as the new benchmark risk-free rate.