Volumes Need to Rise For Libor Transition

Shanny Basar

A Bank of England committee said market awareness of the transition from the Libor rate appears to be strong but there is still significant scope for volumes to increase for products based on the new sterling reference rate.

The UK central bank chaired a meeting of the Working Group on Sterling Risk-Free Reference Rates in July and published minutes on its website last week.

Andrew Hauser, Bank of England

The minutes said: “Andrew Hauser introduced himself as the new executive director for markets and thanked the working group for the work done so far. He noted that Libor transition was likely to be a significant challenge and was accordingly one of the highest priorities both for himself and for the Bank as a whole.”

The Financial Policy Committee of the Bank of England has warned that continued reliance on Libor poses a risk to financial stability that can only be reduced through a transition to alternative rates. Chris Turner, analyst at German investment bank Berenberg, estimated in a report that $30 trillion of assets are benchmarked against sterling Libor.

There have been a series of scandals about investment banks manipulating the Libor interest rate for their own benefit, which resulted in regulatory penalties of $10bn (€8.5bn). As a result, the index is being retired in 2021 and replaced by Sonia – the sterling overnight index average – which is based on actual transactions.

The Bank of England took over as the Sonia administrator and began producing the rate in April this year. The chair introduced a discussion about the use of Sonia in the market.

EIB Sonia-linked bond

“Members highlighted the recent European Investment Bank Sonia-linked bond issuance as an important transition milestone,” added the minutes. “Some members noted the market would need to become more familiar with these types of transactions, particularly the feature in which the interest observation period lags the coupon period by five days in order to provide cash flow certainty.”

In June this year the European Investment Bank printed the market’s first Sonia benchmark with a £1bn ($1.3bn) five-year bond. The bond pays a quarterly interest payment of Sonia + 35 basis points.

Bertrand de Mazières, EIB

Bertrand de Mazières, director general, finance at the EIB, said in a statement: “The choice of referencing the Sonia benchmark removes the need, for both issuers and investors, to consider any future changes to Libor for this bond.”

Kerr Finlayson, director, SSA syndicate at RBC CM, said in a statement: “Broad demand across over 50 separate investors clearly highlights this point and the fact that they were able to achieve demand in excess of £1.55bn for what’s effectively a new product is massively impressive. Kudos to the team for the time spent behind the scenes testing processes and making sure all the settlement side of things works as well – this is obviously going to be key as we look to expand the depth of the product as Sonia is widely expected to become the default reference rate in sterling”.

Sonia futures

The market has begun to develop products for the new reference rates in sterling and other currencies. CME Group, the US exchange, said last week it would be launching Sonia futures, pending regulatory review:

CME Group is introducing two Sonia contracts – a quarterly International Monetary Market (IMM) dated contract observing the recommended specifications of the Working Group on Sterling Risk Free Reference Rates; and a Bank of England Monetary Policy Committee (MPC) meeting dated contract.

Agha Mirza,
CME Group

Agha Mirza, CME Group global head of interest rate products, said in an email to Markets Media that the CME Quarterly IMM SONIA futures will observe the recommendations of the Working Group on Sterling Risk Free Reference Rates and are based on extensive client feedback on design of future contracts for alternative reference rates.

“The CME MPC Sonia futures will have contract critical dates that align with the meeting dates of the Bank of England’s Monetary Policy Committee,” he added. “Since underlying short dated interest rates tend to move in discreet fashion based on central bank policy there are many participants across all market segments who may benefit from hedging and managing risk around this vector of dates if they don’t already do so.”

Mirza continued that both the CME Sonia futures are complementary to existing over-the-counter Sonia products.

“Where applicable they will have automatic margin offsets against CME Group’s existing short-term interest rate futures as well as eligibility, down the line, for portfolio margining against OTC interest rate swaps,” he added. “They complement CME Group’s highly successful push into international fixed income markets through OTC Clearing services, where over 24 currencies are supported for interest rate swap clearing including leading presence in several key emerging markets.”

At the meeting ICE, the US exchange, said total ICE Sonia futures outstanding were £15bn and open interest has since reached a record:

CurveGlobal, the London Stock Exchange Group’s derivatives venture, has also launched Sonia futures:

“Awareness of transition in the market appeared to be strong but there was still significant scope for volumes to increase,” added the minutes.

In the swap market, one member of the committee noted at the meeting that there had been a pick-up in SONIA swap (OIS) volumes but liquidity could be patchy.

“Some market participants were nervous about warehousing Libor-OIS risk at longer tenors given the potential risks around Libor discontinuation and the volatile basis at the long end between OIS and Libor,” said the minutes.

The meeting also discussed gathering data to measure the transition from Libor. The Bank of England introduced an initial list of metrics which the central bank and the UK Financial Conduct Authority could start gathering and eventually publish.

“The chair asked for the group’s views on whether publishing metrics of this type would be market moving,” said the minutes. “Some members suggested that these data sets needed to be appropriately aggregated to avoid this risk.”

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