Investigating the pace of adoption and characteristics of risk-free rates and how the industry is being impacted by the transformation

By Sebastien Cross, UK Rates Strategist, Bank of America

In your opinion, how does the pace of adoption between SONIA, SOFR and €STR differ?

The short answer is – a lot! The UK has been ahead of the US and Europe so far owing to the quick choice of a risk-free rate that was already being used by the derivatives market; SONIA. Since then, in derivatives, we have seen liquidity grow across the OIS curve, clearing introduced for all maturities and the introduction of a number of different SONIA-linked futures. In cash, floating rate issuance this year has predominantly been linked to SONIA rather than LIBOR and we have seen our first issuer gain bond holder consent to switch the benchmark of an existing FRN from LIBOR to SONIA. The loan market also saw its first SONIA linked facility priced earlier this year.

In the US the choice of a new rate, SOFR, meant a number of products needed to be created from scratch. We saw the advent of both one month and three month linked SOFR futures last year, with open interest continuing to grow since. There has been a large amount of SOFR-linked FRN issuance mostly in relatively short tenors and from government sponsored entities, although it is still vastly outweighed by LIBOR linked issuance year-to-date. In swaps the number of SOFR-linked derivatives transactions has been growing, but is still dwarfed by LIBOR which remains the primary benchmark for the US derivatives market. There have been very few loans written off of SOFR to date.

In Europe the focus has been on overnight rates, as the newly reformed ‘hybrid EURIBOR’ looks set to continue being published for some time having recently gained regulatory approval. However the lack of transactions underlying EONIA has led to a similar process to find a reliable alternative, resulting in the ECB’s €STR becoming the chosen risk-free rate in EUR. The ECB will begin publishing €STR on daily basis on October 2nd, at which point EONIA will be calculated as €STR plus a spread of 8.5bp. This is aimed at facilitating the ultimate phasing out of EONIA at the end of 2021 with €STR replacing it.

Can you provide our readers with an overview on the differences in RFRs compared to LIBOR?

The main point to highlight is that all the chosen RFRs across the UK, US and EUR are overnight rates, compared to IBORs which are term rates (of varying tenors). This is one of the biggest hurdles for the market to contend with for those jurisdictions that are looking to transition away from IBORs to RFRs; what is the impact of moving from a term rate to an overnight rate? While all three jurisdictions are investigating the prospect of term RFRs (likely derived from RFR-linked derivatives pricing), regulators in both the UK and US are encouraging market participants not to rely on the availability of term rates when planning their transition away from IBORs.

Across the jurisdictions, the UK and Europe have chosen RFRs with similar characteristics; overnight, unsecured, borrowing rates derived from the central banks’ own money market statistical reporting database. In the US, they have chosen an overnight secured rate collateralised by US Treasuries, introducing an added dynamic of repo conditions for US treasuries in to the overall characteristics of their RFR. The common characteristic across all three rates is that they are currently grounded in a large number of transactions every day on average.

What do you think will be some of the key industry milestones ahead of LIBOR phase out?

There are two aspects to focus on as we head towards the potential phase out of LIBOR; is the market comfortable that such an event is accounted for in the stock of existing legacy products across asset classes that are linked to LIBOR and mature beyond the potential phase out date at the end of 2021. Second is the market capable of writing all new business linked to the new RFRs in the absence of LIBOR.

For legacy products the market is at various stages of updating the legal fallback language in existing contracts to account for the potential discontinuation of LIBOR. A large part of this has been driven by public consultations allowing market participants to express their opinion on the preferred methodology and characteristics of new fallback language. The derivatives market is leading the way through ISDA who are looking to have the amended fallback language, agreed through public consultation, in place around year end.

For new business the focus is on developing a full range of products that market participants are comfortable using and that are capable of replacing those currently linked to LIBOR. For example while SONIA swaps have been used for a number of years now, we have only recently seen our first SONIA swaption trade. The SONIA loan market remains in its early stages with a number of participants waiting to see the progress made in developing term RFRs. In the US, liquidity in both SOFR-linked futures and swaps continues to be dwarfed by their LIBOR equivalents and LIBOR also remains the more often used benchmark for floating rate issuance. The planned shift by both CME and LCH next year to SOFR discounting for cleared interest rate swaps should aid liquidity growth in SOFR swaps. Finally in EUR while the market will continue to use EURIBOR, there are plans to go through the same process of amending fallbacks to account for its potential discontinuation at some point in the future. It will also have to contend with the transition from EONIA to €STR and the creation of pure €STR linked products once the rate commences being published in October.