Market hungry for forward-looking RFRs

The end of Libor comes one step closer as consultations with ICE (Intercontinental Exchange) Benchmark Administration (IBA) on end-dates closes and fallback language arrangements for new derivatives came in to effect on Monday.

Concerns remain about a lack of liquidity in the Libor replacement rates have led market participants to look for more guarantees to ensure the risk free rates (RFR) have depth.

One such solution is a new short term credit sensitive index, the Bloomberg Short Term Bank Yield Index (BSBY).

“Just like developing liquidity in any market, it takes a lot of people to come together,” says Umesh Gajria, global head of index linked products at Bloomberg. “There’s a bit of a chicken and egg problem. But once you get a base going, you will see a massive acceleration after that in terms of transition.”

BSBY is a new short term credit sensitive index.

David Mullen, senior product manager at Bloomberg says BSBY aims to support the transition to Sofr by addressing needs Sofr cannot solve on its own.

“The loan industry and the banking industry is eager for a credit sensitive component,” he says.

“Because BSBY is based on the products that banks use to fund themselves, we believe that there is credit sensitivity baked into the index. In conjunction with Sofr, [BSBY] should help grow that market, particularly in the loan area.”

The index uses data from commercial paper, certificates of deposits, US dollar deposits and short-term bank bond trade transactions.

Currently BSBY is only providing rates for Sofr but Mullen says they are looking to expand the index into other Libor-replacements.

“When we started this project back in the summer, we were being encouraged by our clients [in the US] to look at the US dollar Libor and Sofr markets. We’re now at the point because we have a very strong methodology, that we’re starting to look at the possibility of other markets, particularly Sonia and the euro market.”

On top of credit sensitivity, another concern market participants have brought up is that the new RFRs are not forwarding looking. However, David Lawton, managing director and co-head of financial industry regulatory advisory services at Alvarez & Marsal says for most scenarios there is no real requirement for a forward-looking rate other than familiarity.

“The market participant working groups, the Alternative Reference Rates Committee (ARRC) in the US and the Working Group on Sterling Risk-Free Reference Rates in the UK. These working groups have conceded that for many use cases, you don’t need a forward-looking rate, you can have a backward looking rate. The market convention will start to shift in some of those.”

While most loans could adapt to a ‘backward looking’ rate, Lawton does add there is still a need for forwarding looking one.

“For some cases, the working groups are saying and regulators are conceding, you probably do need a forward-looking rate. What market participants are hoping for there is that forward looking rates will emerge which are derived from the RFRs.”

Mullen says BSBY was created to help fulfill that need. The index currently lists overnight rates for one-month, three-month, six-month and twelve-month tenors. Bloomberg is also not the only firm looking to publish a forwarding looking Sofr related rate, IHS Markit also announced its plans to publish then own index in Q2 of 2021.

2021: The end of Libor

With US dollar denominated Libor set to be phased out by December 2021, a joint letter published last year in November by US regulators stressed the need to adopt the new RFR, Sofr as soon as possible. A concern among regulators is that liquidity in Libor could drop as the deadline approaches.

“As liquidity in these new reference rates starts to build up, you can anticipate that liquidity in Libor instruments will start to dry up”, says Lawton. “Therefore, the pricing of those instruments will start to get more volatile. [The regulators argue], firms may find themselves holding these sorts of instruments and trying to transition out of them when actually that becomes very difficult because there is no liquidity.”

In an effort to help ease the transition, the IBA announced it was extending the publishing of US dollar Libor rates by 18 months to June 2023.

Gajria says this extension is targeted toward legacy contracts, many of which mature in or before 2023.

“The extension was more focused on giving some of the banks, clients and market participants more time for some of the tough legacy contracts to expire. It gives a little bit more breathing room for markets to handle uncertain/difficult contracts.”

Lawton says that because Sofr is a completely new rate, it may take a little longer for the transition to occur. However, the extension given by regulators is not an extension for use but for transition.

“Regulators will not want these 18 months of additional grace to be wasted. This is an extension of the transition period to enable the transition to happen rather than a postponement of the transition period.”

The UK will be the first Libor currency to phase out the rate, with the issuing of sterling denominated Libor derivatives set to end in March. Other Libor currencies will be watching to see what happens when Libor ends in the UK.

“Each area is looking for what lessons it can learn from the others,” says Lawton.

“I think you can expect that the sterling markets, which are going to be temporarily out front will be looked to for lessons, particularly solving some of these technical challenges. These will then be read across into dollar markets and euro denominated markets subsequently.”