The Bank of England’s working group on the transition from Libor to a new risk-free reference is reviewing the use of compression auctions to decrease risk during the changeover.

The UK central bank, led by Mark Carney, published the minutes of the Working Group on Sterling Risk-Free Reference Rates from December 2018 on its website this week. The working group consists of experts from large sterling swap dealers and discusses the development of sterling risk-free reference rates.

After the financial crisis there were a series of scandals regarding banks manipulating their submissions for setting benchmarks across asset classes, which led to a lack of confidence and threatened participation in the related markets. As a result, regulators have increased their supervision of benchmarks and want to move to risk-free reference rates which are based on transactions, so they are harder to manipulate and more representative of the market. The UK has adopted the Sterling Overnight Index Average (Sonia) as its new risk-free reference rate to replace sterling Libor.

Professor Darrell Duffie from Stanford University gave a presentation at the December meeting of the working group on his recent work on compression auctions.

Compression allows clients to “tear-up” offsetting trades in their portfolios to reduce the notional outstanding and the number of line items in their portfolio while maintaining the same risk exposure. Use of compression services in the derivatives market following the introduction of stricter capital requirements, such as the Basel III leverage ratio, which has led to banks reducing their balance sheets and capital efficiency becoming increasingly important.

Professor Duffie explained that a compression auction (or a cycle of such auctions) could reduce the amount of long-dated legacy Libor swaps, by converting centrally cleared contracts referencing Libor to contracts referencing a different benchmark (e.g Sonia). The compression algorithm would be both an auction mechanism (matching opposite positions to convert them) and a compression mechanism.

“Indeed, using input from participants (bids and offers) the mechanism would determine the compensation rate to be paid by Libor payers and received by Libor receivers when converting their contracts to the new (lower) benchmark,” added the minutes. “The mechanism would also increase conversion by allowing some substitutability between positions of sufficiently similar maturities, within risk tolerances specified by each participant.”

Duffie continued that an auction would concentrate liquidity and if successful would attract enough participants with offsetting Libor positions (payers and receivers) which would be matched and converted, therefore minimising any Libor risk that needs to be warehoused. He stressed that regulators need to be aware of the incentives for dealers and should consider recognising netting benefits to increase incentives to participate in such auctions and also suggested they consider how such auctions could operate within the relevant regulatory frameworks.

The working group agreed to examine these techniques further.

Francois Jourdain from Barclays, chair of the working group, then provided an outline of 2018 highlighting that its size increased from 16 banks to around 130 firms last year. He said 2019 should be an implementation/execution year of some of the agreed actions. Jourdain then handed over to the new chair, Tushar Morzaria, group finance director of Barclays, and welcomed him to the effort on Libor transition.

Sonia Derivatives

CurveGlobal said this week that open interest in three-month Sonia futures reached a record 34,952 on 14 February. The London Stock Exchange Group’s interest rate derivatives venture launched futures based on Sonia in April last year.

@CurveGlobal weekly dashboard: record total Open Interest 487,189, Euribor 250,945, 3M Sterling 201,335 and 3M SONIA 34,952. Total Open Interest has grown by 40% year to date. #futurestrading pic.twitter.com/ApbccIunjv

— CurveGlobal (@CurveGlobal) February 19, 2019

Rival ICE also provides trading of Sonia futures and said this week that it has reached record volumes:

SONIA volumes reached £56.7 billion across the 1M and 3M contracts with cumulative notional now exceeding £1.50 trillion. https://t.co/qW0HeBeKDk pic.twitter.com/NupDU8AFAM

— ICE (@ICE_Markets) February 19, 2019

Edwin Schooling Latter, director of markets and wholesale policy at the UK’s Financial Conduct Authority, gave a speech on Libor transition at the International Swaps and Derivatives Association’s annual legal forum in London last month. He said the increase in monthly volume of cleared notional in Sonia swaps shows that the derivatives market is making progress in moving away from Libor.

Schooling Latter said the share of cleared sterling swaps referencing Sonia has grown over the past two years to 19% in the second half of last year, from 11% in the first half of 2016, citing data from LCH, the London Stock Exchange Group’s clearing house.

“In notional terms it is a far higher share,” he added. “In fact, on a monthly basis, cleared notional in Sonia swaps is now higher than that for sterling Libor.”