Alternative reference rates
The global transition to new benchmarks
The global transition to new benchmarks
As a new era for reference rates dawns, industry is making the shift to alternatives, with implications across the finance landscape.
As the incumbent benchmark, the London Interbank Offered Rate (LIBOR) effectively underpins hundreds of trillions globally in financial products. Now, regulators are urging the adoption of new benchmarks, ahead of reforms which will see LIBOR wound down by the end of 2021.
Enter “alternative reference rates”…
What is a reference rate?
A reference rate is a benchmark interest rate used to determine other interest rates. For example, LIBOR provides an indication of the average rates at which LIBOR panel banks could obtain wholesale, unsecured funding for set periods in particular currencies. Lenders then use this rate to determine interest rates for a variety debt instruments - such as mortgages and commercial loans - and financial products like derivatives.
The need for benchmarks to be based on transparent, arms-length transactions has been reinforced by global regulators, including The Financial Stability Board and the International Organization of Securities Commissions.
In response, industry has started to utilize a raft of alternative reference rates, and from the AONIA (Australian Interbank Overnight Cash Rate) to SARON (Swiss Average Rate Overnight) strategies are in place to embrace new benchmarks.
Already, Morgan Stanley, Wells Fargo,
JP Morgan, Citigroup and Goldman Sachs have all referenced SOFR in bond transactions.
Already, Morgan Stanley, Wells Fargo, JP Morgan, Citigroup and Goldman Sachs have all referenced SOFR in bond transactions.
The Sterling Overnight Interbank Average (SONIA) has been chosen by the Working Group on Sterling Risk-Free Reference Rates as the U.K.’s preferred alternative reference rate.
As a transaction-based benchmark, SONIA reflects the average interest rates that banks pay to transact sterling overnight from other financial institutions.
SONIA has been a benchmark since 1997. The Bank of England became its administrator in 2016, and later implemented reforms to strengthen its methodology. This involved broadening SONIA’s scope of overnight unsecured deposits to help bolster underlying transaction volumes - average cleared over-the-counter SONIA swaps exceeded £4.5trillion per month over the past six months, and the traded monthly notional value is now broadly equivalent to Sterling LIBOR.
Adoption is underway. The European Investment Bank earlier issued a £1 billion 5-year SONIA linked floating rate note, while Santander U.K. and Lloyds Bank each issued their second SONIA-linked covered bond last year. The U.K.’s biggest port operator - Associated British Ports - became the first company to switch an existing issue from LIBOR to SONIA last June, while U.K. bank NatWest announced the delivery of its first SONIA loan for a corporate customer last July, as part of a pilot with a limited number of large clients.
ICE is the market leader in alternative reference rates, with volume traded in its SONIA futures exceeding £5.7 trillion notional. SONIA futures trade alongside our existing interest rate futures and options, along with inter-contract spreads. ICE’s interest rates derivatives clear through ICE Clear Europe, enabling up to 80% margin offsets depending on expiries/currencies.
In North America, the Secured Overnight Financing Rate (SOFR) has been recommended by the Alternative Reference Rates Committee (ARRC) as a benchmark replacement.
SOFR is an overnight reference rate that broadly measures the cost of borrowing cash with U.S. Treasuries as collateral.
Following SOFR’s introduction by the Federal Reserve Bank of New York in 2018, use of the index has grown steadily with over $USD37 trillion in cumulative trading of futures, $USD700 billion of Swaps and overall issuance tied to SOFR past $USD360 billion.
Already, banks including Morgan Stanley, Wells Fargo, JP Morgan, Citigroup and Goldman Sachs have all referenced SOFR in their bond transactions.
The SOFR rate is published daily by the New York Fed based on data collected on over $USD800 billion in secured overnight repurchase transactions. These represent the largest underlying volumes of any U.S. money market, underscoring SOFR’s stability. The New York Fed has also outlined plans to produce SOFR averages across various terms, and an index to allow the calculation of averages over custom periods. These averages aim to further boost market confidence, as participants start constructing new SOFR-based contracts.
The ARCC has said it will support the publication of a forward-looking SOFR term rates with a transparent calculation methodology, as SOFR’s liquidity grows.
ICE Futures Europe offers One Month and Three Month SOFR futures, with open interest continuing to build.
"ICE is a leading exchange in Benchmark Reform listed products, offering 1M and 3M futures in both USD and GBP alternative reference rates. Futures play a fundamental role in price discovery and term structure in interest rate curves. The ICE Exchange offers economically efficient and transparent access to trade and hedge the new reference rates." Matthew Horton - ICE Director, Head of Interest Rate Derivatives
|Currency||United Kingdom||United States|
|Index Availability||Launched in 1997 by the WMBA, BOE took on administration April 2016||FRBNY began publishing April 2018|
|RFR Administration||Bank of England||Federal Reserve Bank of New York|
|Secured or Unsecured||Unsecured Rate||Secured Rate|
|Regulatory Body||Bank of England (BOE)||Federeal Reserve (Fed)|