Interest rate swaps based on Libor continued to be executed yesterday despite UK regulators wanting market makers to transition away from the reference rate on March 2.
The Bank of England and the Financial Conduct Authority encouraged market makers to use Sonia as the standard reference rate for sterling interest rate swaps from March 2.
Chris Barnes at derivatives analytics provider Clarus Financial Technology monitored swaps being reported yesterday. He said on the firm’s blog that there was not a decisive switch as both Sonia and Libor swaps were traded.
“What this means is that secondary instruments, such as swaptions and cross-currency swaps, remain firmly Libor-centric. It was not expected for these markets to transition today, but it does help to highlight how long a complete transition will take,” he added. “There are a lot of markets still addicted to Libor.”
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After the financial crisis there were a series of scandals regarding banks manipulating their submissions for setting benchmarks across asset classes, which led to a lack of confidence and threatened participation in the related markets. As a result, regulators have increased their supervision of benchmarks and want to move to risk-free reference rates based on transactions, so they are harder to manipulate and more representative of the market.
The UK has chosen the sterling overnight index average, Sonia, as its risk-free rate. The FCA said two years ago that it will not compel panel banks to submit to Libor beyond 2021.
Barnes said that yesterday there were 149 Sonia trades with a notional of £225bn ($228bn) versus 238 Libor trades with a notional of £13.2bn. The majority, 82%, of Sonia risk transacted was two years or shorter with just two Sonia trades with maturities longer than 10 years.
“The amount of risk traded in GBP Libor five-year and ten-year swaps alone was equal to the total Sonia risk traded today,” he added. “Liquidity in those two benchmark tenors has to transition to Sonia products before we can consider that the market convention for sterling swaps has moved to Sonia.”
Clarus’ analysis is based on US data from US swap data repositories, which are more transparent than in Europe. However, the firm believes US SDR data to be representative of the market as a whole.
Bank of England
Andrew Hauser, executive director, markets at the Bank of England said in a speech last month that progress on Libor transition has been made in the sterling derivatives market with approximately half of new cleared sterling swaps referencing Sonia last year.
Hauser spoke at the International Swaps and Derivatives Association/SIFMA Asset Management Group Benchmark Strategies Forum 2020 in London.
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Although there has been progress in the swaps market, he said Sonia also needs to be increasingly used in futures and non-linear products.
“In preparation for the provision of a robust forward-looking sterling term rate, many banks are now streaming executable Sonia swap prices to regulated trading venues,” added Hauser. “Having the inter-dealer market able to trade Sonia in a single click is a key building block to helping firms hedge with the smallest friction possible.”
The Bank of England’s working group will be considering what more needs to be done to drive transition in these markets over the coming months.
In order to accelerate the transition to Sonia the UK central bank is going to publish a new Sonia daily index and discourage the use of Libor-linked collateral.
Hauser said: “2020 is a critical year for Libor transition. Great progress was made in 2019, particularly in sterling wholesale markets but there is still a lot of ground to cover – particularly in the cash markets.”
The Bank of England set up a Risk Free Rate Working Group, under the leadership of Barclays’ chief financial officer Tushar Morzaria, which has published a road map for the transition.
The minutes for the task force's January meeting were published at the end of last month. The minutes said attendees noted particular progress in sterling but there was general acknowledgement that loan markets were lagging behind globally.
“The task force was working on a granular plan for transitioning to Sonia linked lending aligned to the working group’s headline target to cease issuance of sterling Libor based cash products maturing after 2021 by the end of the third quarter of 2020,” said the minutes. “Conventions were another key focus and the group was working closely with the infrastructure and loans sub-groups.”
CEO letters
In addition, the FCA wrote to the chief executives of asset management firms on February 27 saying they needed to prepare for the end of Libor.
The letter said: "We expect your firm to take all reasonable steps to ensure the end of Libor does not lead to markets being disrupted or harm to consumers, and to support industry initiatives to ensure a smooth transition. Firms, such as yours, in the asset management sector, should be in no doubt that they have a responsibility to facilitate and contribute to an orderly end to Libor.”
The FCA continued that firms should not expect or base their transition plans on future regulatory relief or guidance on legislative solutions. The regulator added that if asset managers have Libor exposures or dependencies, their transition activities should now be underway.
“If Libor transition is not yet underway at your firm, we expect you to take immediate action to develop and to begin to execute an appropriate plan,” said the FCA. “If your board decides that no Libor transition plan is needed, we may seek to understand and, where appropriate, challenge the reasons for this decision.”
