Grief is said to exist in five phases: denial, anger, bargaining, depression and acceptance. Derivatives users are experiencing a similar range of emotions as they switch from Libor to alternative risk-free rates. Now, regulators have added a feeling of urgency after giving banks a deadline to shift interdealer swap activity to the alternative risk-free rate for sterling markets, Sonia.
The move intensifies the pressure on dealers to ditch the mistrusted benchmark and adopt Sonia as the standard way of pricing new trades by the end of March. Despite a nagging sense that not all participants have made the necessary upgrades to systems and infrastructure to handle the new fixing, dealers accept the rationale for the change.
“To be able to move the balance to Sonia within the interdealer market, making Sonia the market convention is exactly the right thing to do,” says a senior rates trader at a US bank.
“We always knew this would happen,” adds Phil Lloyd, head of market structure and regulatory customer engagement at NatWest Markets. “It’s just a question of when it would happen and what the catalyst for it would be.”
The Financial Conduct Authority’s Edwin Schooling Latter told an audience at Risk.net’s Libor Summit on November 21 that while Sonia is already the norm in new issuance of floating rate sterling bonds and securitisations, significant volumes of new Libor swaps maturing after the end of 2021 – the date which Libor is expected to cease – are still being struck.
Year-to-date volumes of Sonia-based overnight index swaps stood at £3.55 trillion ($4.62 trillion) versus volumes of Libor instruments, including interest rate swaps and forward rate agreements, at £2.62 trillion, according to clearing house LCH’s latest data.
“In sterling interest rate swap markets, we will be encouraging market-makers to make Sonia the market convention from Q1 2020,” said Schooling Latter, the FCA’s director of markets and wholesale policy. “That does not, at this stage, mean no more sterling Libor swap transactions for those who have a particular reason to prefer Libor, but it does mean making it standard to quote and offer swaps based on Sonia rather than Libor.”
Sonia liquidity has traditionally been concentrated at the short end of the curve, with Libor remaining the dominant fixing for longer-dated swaps. But, anecdotally, Sonia volumes are starting to grow at the long end due to greater activity by insurers and liability-driven investment funds, particularly in the final two months of 2019. LCH was unable to provide a breakdown of sterling swap volumes by tenor.
“The short end of the sterling market is principally Sonia-based flow,” says Alistair Sharp, Credit Suisse’s head of interest rate trading for Europe, the Middle East and Africa. “90% of the over-the-counter business that I do has some element of Sonia to it – whether that’s Sonia only or Sonia versus Libor – so to a large degree that side of the market has already transitioned. The goal is now for the medium and long end of the market to transition to Sonia now too.”
The US bank’s senior rates trader says long-dated volumes are now evenly split between Sonia and sterling Libor, so dealers have little excuse not to use Sonia as the norm.
“The reality is that there is nothing stopping dealers from trading Sonia with each other, other than the fact that the market infrastructure is set up for Libor and has been for a while,” says the trader. “But that infrastructure needs to change and I think Q1 2020 is as good a point as any other.”
Full stream ahead
To hasten the shift to Sonia, interdealer central limit order books (Clobs) would need to start streaming Sonia prices, traders say. Currently, trades occur via request-for-quote protocols.
“The more people can see prices then the more people can deal on them and mitigate risk on them, which in turn will result in more Sonia liquidity,” says Credit Suisse’s Sharp. “Streaming Sonia prices is part of the process that will make Sonia more dominant.”
To this end, the FCA is working with dealers, platforms and other infrastructure providers to move Sonia swap trading on to lit markets. Speaking on a Risk.net webinar in October, Dan Marcus, chief executive of Trad-X, confirmed his platform already has Sonia swaps in its testing environment ahead of a planned launch of the full service in the first quarter, with a transition period due to start in February.
Members of the working group on sterling risk-free rates, convened by the Bank of England, have committed to stream executable quotes for one-, three- and six-month Sonia overnight index swaps from February, according to the minutes of the November meeting.
It’s a case of changing the mindset of the interdealer market and getting them to accept the fact that in the near feature they’ll be delivered basis risk if they do a trade versus Libor as opposed to a trade versus Sonia
Senior rates trader at a US bank
The US bank’s senior trader believes Sonia streaming might pose a challenge for dealers who don’t currently have the set-up or capability to do so, but those parties should be in the minority.
“A lot of people are already streaming and providing pricing in Sonia swaps to clients so this isn’t that big an ask in terms of the costs or technology involved,” the trader says.
“It’s more a case of changing the mindset of the interdealer market and getting them to accept the fact that in the near feature they’ll be delivered basis risk if they do a trade versus Libor as opposed to a trade versus Sonia. That’s a big change for the market to get its head around,” the trader adds.
Basis risk would affect counterparties who are left holding Libor exposure in a market that is increasingly moving to Sonia.
While Credit Suisse’s Sharp agrees that a reasonably liquid electronic marketplace already exists for Sonia at the short end of the curve due to a lot of activity from pension funds, bank treasuries and corporates, this is less the case for the medium end of the Sonia curve due to a lack of demand from end-users.
“Unfortunately, to get a Sonia Clob you need more than just a bunch of market-makers willing to provide prices, you also need end-user demand. That’s the part which is more challenging but we’re all doing our bit to make sure we can facilitate this,” he says.
As well as helping the swaps market in particular to shift away from Libor, the streaming of firm Sonia swap prices through Clobs is also deemed a crucial step to transition other parts of the derivatives market to the risk-free rate.
For example, swaptions and many rate-linked structured products rely on the Ice swap rate – a measure of term swap rates out to 30 years – for settlement. Ice Benchmark Administration, which manages and publishes the Ibor-based rate for sterling, US dollar and euro, currently takes live swap pricing from three multilateral trading facilities, BGC Partners’ BGC Trader, Icap’s i-Swap and Tradition’s Trad-X.
Following an initial consultation on its planned overhaul for the Ice swap rate – partly fuelled by recent publishing failures of the rate in the US – IBA is expected to finalise its approach for an introduction of a Sonia-based variant of the Ice swap rate to run alongside the existing Libor version. The final methodology consultation is planned for early 2020.
The development of Sonia trading on Clobs would also help along the production of forward-looking term rates based on the overnight benchmark. These rates, which the FCA wants reserved for niche areas of the market only, will be based on tradeable futures and short-dated Sonia swap quotes.
In sterling interest rate swap markets, we will be encouraging market-makers to make Sonia the market convention from Q1 2020
Edwin Schooling Latter, FCA
Swaptions have made a slower start to the switchover. In August, NatWest Markets and HSBC became the first banks to trade Sonia-linked swaptions, but little progress beyond a few token trades has been made so far.
While traders expect that a Sonia alternative to the Ice swap rate will help nudge along the uptake of Sonia swaptions, the products haven’t gained much traction. This is because liquidity in swaps – which banks use as a hedge – is still concentrated at the shorter end of the curve, whereas swaptions are often used by long-dated investors like asset managers and pension funds. A lack of observable Sonia swap levels at those maturities also makes pricing the swaptions difficult, with limited liquidity meaning that Sonia swaptions are likely to be priced higher than Libor swaptions.
“Libor is still the hedging instrument of choice within the interdealer market and so the cost of a [swaptions] trade against Libor is the cheapest. That cost argument wins over the risk-free rate argument and so volume still ends up sitting in Libor,” says the US bank’s senior rates trader.
For the swaptions remaining linked to Libor, banks also aren’t keen to create basis risk. For example, the trader says users will likely still want to hedge their Libor swaptions portfolio with Libor swaps.
However, a move to a world where Sonia is the interdealer standard would hugely simplify the current way banks hedge longer-dated swaps. Currently, a trader would have to hedge a fixed versus Sonia swap with a six-month Libor swap first, as it is the most liquid product. It would then need to conduct a basis swap between six-month Libor and three-month Libor, which allows it to then enter into three-month Libor versus three-month Sonia basis swaps – the most liquid Libor to Sonia instrument – as a final step.
“Essentially there are three hedge trades you have to do whenever you’ve got a fixed trade versus Sonia with an end-user,” says the US bank’s rates trader. “That’s what this Q1 2020 goal is trying to move the needle on.”
Carrot or stick
While helpful, the trader believes that regulators could also do more to help market participants in their transition to Sonia than simply giving the market a Q1 2020 goal, suggesting regulators give firmer guidance or explicit targets for how they expect to see Sonia volumes develop.
“Something in that vein would be helpful and the working group obviously has a role to play here as well in terms of disseminating that message,” says the trader.
NatWest’s Lloyd agrees that additional regulatory guidance would be helpful, pointing to the success of the FCA’s Dear CEO letter in particular.
“The Dear CEO letter was a big point where the market realised that this transition was actually happening and because of that there was a general move more towards Sonia than Libor,” he says.
“The regulatory tone in the UK market has increased a lot over the past 12 months and this most recent speech by Schooling Latter [on November 21] has continued to increase the pressure on market participants to move off Libor. The more that pressure and momentum builds – and the more things in the industry become clearer – then the more the end-user view that Libor is actually ending will harden, and more trading will be done in Sonia as a result,” he adds.
Failing additional regulatory guidance, Credit Suisse’s Sharp believes that regulation itself would pave the way for a greater Sonia boost – such as if leverage ratio add-on exemptions or reduced risk-weighted asset weightings for dealers trading Sonia were offered.
“I think that would be the single biggest boost to Sonia trading within the interdealer market and a way to incentivise early adoption,” says Sharp.
However, Lloyd disagrees that such an extreme measure from regulators is necessary given that the Sonia market is liquid and that the majority of clients are now looking to trade it. Rather than regulatory intervention in the form of capital relief, Lloyd expects regulatory scrutiny of market participants who continue to trade Libor to significantly increase instead.
As Libor nears its predicted death, users may have to reach the acceptance stage sooner rather than later.
Sonia and invoice spread trading
Invoice swap spread trading – a popular interdealer trade that typically involves buying a gilt future and paying fixed on a related interest rate swap with a similar risk profile, and vice versa – could also facilitate the Sonia shift.
As the majority of such interest rate swaps are currently pegged to Libor, traders expect that a switch to Sonia in the swap leg could be a key driver of Sonia becoming the market convention.
“Invoice spread trading is quite popular in the interdealer market and again there’s no reason why you’d choose to trade Libor over Sonia except for the fact that you want to manage your risk with whatever the more liquid instrument is, and right now that’s Libor,” says a rates trader at a US bank.
“There’s a bit of a chicken-and-egg problem here as liquidity doesn’t move from Libor because it’s the more liquid instrument to do your hedging, and because people use Libor for their hedging it stays as the most liquid instrument. That’s why this Q1 2020 goal is a step in the right direction as it will effectively focus minds to proactively transition to Sonia,” the trader continues.
Editing by Alex Krohn