Alternative Reference Interest Rates

Introduction
The Alternative Reference Interest Rates refers to the alternative reference benchmark rates that will eventually replace LIBOR as the benchmark for financial instruments and transactions.

ICE LIBOR is the most widely used interest rate benchmark in the world. LIBOR is calculated and published daily across five currencies and seven maturities by the ICE Benchmark Administration and based on submission by panel banks. This benchmark is meant to reflect the cost at which large, globally active banks can borrow on an unsecured basis in the “wholesale” markets. LIBOR is currently used as a reference rate for more than $350 trillion in notional amount of financial contracts in the cash and derivatives market.

Despite its wide acceptance and use as a reference rate, it has been increasingly losing its relevance post the 2007 financial crisis. The interest rate submissions made by the panel banks are based on a highly liquid unsecured wholesale money market. There has been a significant decline in the unsecured wholesale borrowings by banks mainly as a result of them moving towards secured borrowing transactions such as repos. (It is estimated that the underlying transaction volumes are less than $500 million per day) This has resulted in the rate submissions made by banks based on expert judgement rather than on actual reference to the underlying unsecured wholesale market. Added to this, many banks in the panel have grown uncomfortable in providing submissions based on expert judgement and may eventually choose to stop submitting altogether. Two banks, namely BNP Paribas and Societe Generale, have already stopped submitting to USD LIBOR since 2016; and there are more such banks to follow. Under the current regulations, the regulators cannot force any banks to be in the LIBOR panel beyond two years. The Financial Conduct Authority (FCA) had recently stated publicly that it had to exert significant effort in convincing banks to remain on the LIBOR panels and that it would not persuade or compel banks to make LIBOR submissions beyond the end of 2021. As a consequence, the future of LIBOR beyond 2021 is uncertain. In fact, the FCA had advised that firms should treat LIBOR’s end as something that will occur and not as a remote “black swan” event.

Apart from the above, the Financial Stability Oversight Council (FSOC) has noted that LIBOR is potentially unsustainable and does not meet the robust, transaction-based market interest benchmark as envisioned by the international standards for benchmarks as set forth in the International Organization of Securities Commissions (IOSCO).

Because LIBOR, and particularly USD LIBOR, is used in such a large volume and a broad range of financial products and contracts, the uncertainty surrounding LIBOR’s sustainability poses a potential threat to the safety and soundness of individual financial institutions and to the financial system. Without advance preparation, a sudden cessation of such a heavily-used reference rate would cause considerable disruptions to, and uncertainties around, the large gross flows of LIBOR related payments and receipts among many firms. It would also impair the normal functioning of a variety of markets, including business and consumer lending.

Hence, financial markets need a durable and more robust alternative interest rate benchmark(s). In pursuit of this urgent need, regulators in various countries have responded by creating new benchmarks or reforming some existing benchmarks. These new benchmarks are commonly and collectively referred to as “Alternative Reference Rates”. The following are some of the alternative reference rates selected by major currency areas. Most of them have selected some form of overnight rate.

Jurisdiction	Working Group	Alternative Rate	Secured vs. Unsecured	Overnight vs. Term	Rate Administrator
United States	Alternative Reference Rates Committee	Secured Overnight Financing Rate (SOFR)	Secured	Overnight	Federal Reserve Bank of New York
United Kingdom	Working Group on Sterling Risk-Free Reference Rates	Reformed Sterling Overnight Index Average (SONIA)	Unsecured	Overnight	Bank of England
Switzerland	The National Working Group on Swiss Franc Reference Rates	Swiss Average Rate Overnight (SARON)	Secured	Overnight	SIX Swiss Exchange
Japan	Study Group on Risk-Free Reference Rates	Tokyo Overnight Average Rate (TONAR)	Unsecured	Overnight	Bank of Japan
Euro Area	Working Group on Risk-Free Reference Rates for the Euro Area	Euro Short-Term Rate (ESTER)	Unsecured	Overnight	European Central Bank

It is possible that LIBOR might still be there beyond 2021. However, it is expected that its popularity and usage would be greatly diminished. The new alternative benchmark rates have already started becoming popular. They are expected to replace LIBOR based transactions over time. For the current being, out of the $350 trillion of the notional amount of financial instruments linked to LIBOR, about 80% of them are linked to derivative contracts. Hence, the urgency and need for a robust and dependable Alternative Reference Interest Rate for all currencies.

The following paragraphs describe the Alternative Reference Rates in some countries.

Secured Overnight Financing Rate (SOFR)

In the US alone, the USD-LIBOR linked transactions are worth about $200 trillion in notional value. A majority of this (around 95%) is in derivative contracts, the rest being used in business loans, retail mortgages, consumer loans, floating rate debt, and securitization instruments. Many of these contracts will roll off before 2021. The following table shows the estimated USD-LIBOR market footprint by Asset Class.



Due to the vast volumes of transactions, the need for an alternative reference rate and the sense of developing its own USD reference rate instead of depending on London or other business centers, the Federal Reserve Board formed a committee named “Alternative Reference Rates Committee (ARRC)” comprised of group of market participants, the Federal Reserve Board, The New York Fed, the U.S Department of Treasury (Treasury), the U.S. Commodity Futures Trading Commission (CFTC), and the U.S. Office of Financial Research (OFR) to identify an alternative reference rate for use primarily in derivatives contracts. The ARRC was charged with finding a rate that was more firmly based on transactions from a robust underlying market and that would comply with certain standards, including the IOSCO Principles for Financial Benchmarks. The ARRC was also tasked with the preparation of a plan to facilitate the acceptance and use of the selected alternative reference rate on a voluntary basis.

The ARRC conveyed its first meeting on December 2014. Given the focus on alternative reference rates for derivatives at the time of its inception, the ARRC, on June 22, 2017, identified the Secured Overnight Financing Rate (SOFR), as its recommended alternative to USD LIBOR.

The SOFR is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. SOFR is published by the Federal Reserve Bank of New York and is determined based on the following.

1. Tri-party repurchase agreements (repos)
2. General Collateral Finance (GCF) repos; and
3. Bilateral Treasury repo transactions cleared through Fixed Income Clearing Corporation (FICC)

In terms of the transactions underpinning SOFR, it has the widest coverage of any Treasury repo rate available. The transaction volumes underlying SOFR are far larger than the transactions in any other U.S. money market and dwarf the volumes underlying LIBOR. The following graph shows this comparison.




SOFR is a good representation of general funding conditions in the overnight Treasury repo market. As such, it will reflect an economic cost of lending and borrowing relevant to the wide array of market participants active in the market, including not only broker-dealers, but also money market funds, asset managers, insurance companies, securities lenders, and pension funds.

The following are the features of SOFR.

1. It is IOSCO compliant
2. It is fully transaction based
3. It encompases a robust repo market with more than $700 billion in daily transactions.
4. It is an overnight nearly risk-free reference rate that correlates closely with other money market rates; and
5. It covers multiple repo market segments allowing for future market evolution.

SOFR will take time to evolve as a full replacement of LIBOR, as SOFR is currently only a overnight rate, unlike LIBOR which has both overnight and term rates. Thus, there is a planned transition from LIBOR to SOFR. The following is roughly the transition plan.

1. To encourage SOFR linked Futures
2. To encourage SOFR linked OIS
3. CCPs are expected to provide their members with a choice of clearing instruments using discount curves based on SOFR.
4. Paying SOFR interest on collateral posted
5. SOFR discount curves
6. SOFR Term Rate based on SOFR linked derivatives.

The SOFR is administered by the New York Fed. It will publish SOFR on a daily basis on its website at approximately 8:00 am eastern time. The following is a snapshot of the SOFR rates as reported by The New York Fed.



Currently, the SOFR is a overnight rate. It is expected to be used in the derivatives market. Unlike LIBOR it does not have a Term Rate. The ARRC is working on developing a Term Rate using derivatives on SOFR. Once a Term Rate is developed, it can be used in a variety of financial products.

With regard to its use in derivatives, the ARRC has encouraged market participants to develop the required “fallback” legal language so that in the event of LIBOR not been published beyond 2021, SOFR can be used without much disruption to pricing and valuations. The “fallback language” refers to the legal provisions in a contract that apply if the underlying reference rate in the product (e.g. LIBOR) is discontinued or unavailable. The market participants have to understand their contractual fallback arrangements and ensure that those arrangements are robust enough to prevent potentially serious market disruptions in a LIBOR cessation event.

Fallback provisions for LIBOR in derivatives contracts currently trigger only if a temporary cessation of LIBOR occurs (e.g. a computer glitch) and may not be workable and could lead to an unintended economic outcome if LIBOR ceases to be published. ISDA has plans to publish a multilateral protocol to assist market participants in including the amended definitions (i.e. the definitions with fallbacks for benchmark cessations) in legal swap contracts. ISDA, at the time of this writing, has not yet finalized its fallback language primarily because of plans to apply both a credit spread adjustment and a term fixing adjustment at the time of the fallback to SOFR. In order to select the best methods for calculating such adjustments, ISDA will be inviting market participants to weigh in on a number of proposed methodologies during market-wide consultations, the first of which is open until October 12, 2018.

The SOFR has gained acceptance among the market participants and in further developing its usage the Chicago Mercantile Exchange (CME) has launched two SOFR Future contracts - 1 month contract (SR1) and 3 months contract (SR2).

Contracts referencing SOFR are usually based on an average of daily interest rates over a given period of time. These averages of SOFR are quite smooth compared to SOFR itself. Most instruments use either a compound or linear average of SOFR over a fixed period of time as the floating rate paid under the terms of the contract, not a single day’s realization of SOFR.

Overnight rates in the repo market are inherently volatile, and the dynamics that generate much of the volatility include settlement of treasury securities, and balance sheet management during quarter-ends. While these features of Treasury repo market can contribute to some day-to-day volatility of SOFR, the volatility has little impact on the averages of SOFR that are used in financial contracts. The below graph shows this feature and also the comparison with LIBOR volatility.

Reformed Sterling Overnight Index (SONIA)

The Sterling Overnight Index Average (SONIA) reflects the bank and building societies’ overnight funding rates in the sterling unsecured market. The Bank of England is the administrator of SONIA effective April 2016. Unlike LIBOR and EURIBOR, but like EONIA, SONIA is based on actual transactions. It is calculated using volume-weighted trimmed mean on eligible sterling denominated deposit transactions and is published daily. It is rounded to four decimal places. The trimmed mean is calculated as the volume-weighted mean rate, based on the central 50% of the volume weighted distribution of rates.

Not all wholesale unsecured loans are considered for calculation. The following are some basic criteria for transactions to be included in calculation.

• They should be unsecured and of one business day maturity.
• They should be executed between 00:00 hours and 18:00 hours UK time and settled the same day; and
• They should be greater than or equal to GBP 25 million in value.

SONIA is published at 09:00 on the London business day following that to which the rate pertains. The following information is published.

• Aggregate volume
• The rate occurring at the 10th percentile of volume
• The rate occurring at the 25th percentile of volume
• The rate occurring at the 75th percentile of volume
• The rate occurring at the 90th percentile of volume

In order to recover its cost in producing the benchmark, the Bank of England has specified certain activities which require users to have licenses from the bank. The following are the permitted activities.

• The redistribution of SONIA data to clients.
• The creation of derivative products referencing SONIA listed on futures exchanges
• The use of SONIA in providing clearing services; and
• The use of SONIA for valuation of client’s portfolio(s) including discounting.

Bloomberg and Thomson Reuters publish SONIA under license from the bank. The ISIN for SONIA is GB00B56Z6W79.

Swiss Average Overnight (SARON)

SARON replaced the earlier TOIS (Tom Overnight Index Swap) from September 2013. TOIS was the average of unsecured CHF lending rate among 30 Zurich-based banks for tom/next period. Unlike other overnight rates, it is based on indicative, not tradable, rates. It is computed by the broking firm Cosmorex AG and is used as the floating rate benchmark for CHF overnight indexed swap (OIS). TOIS has the following limitations: (1) It is indicative, not tradeable rate; (2) the liquidity for tom/next (T/N) tenor is far less than overnight tenor; (3) in the post 2007 credit crisis period, the short term funding is done through repo trades rather than unsecured lending.

SARON is developed in 2009 by Swiss National Bank and its computation is handled by SIX Swiss Exchange. It is calculated in real-time and published every 10 minutes based on the actual repo rates and tradable repo rates on Eurex Zurich Ltd’s trading system. In addition to real-time rates, the fixing is conducted three times a day at 12 noon, 4:00pm and 6:00pm Zurich time. SARON differs from other overnight rate indices because it is a repo rate (which is secured lending) while all others, except SOFR, are rates for unsecured loans.

The following are some of the features of SARON.

• It is representative reference rate of the Swiss money market.
• It is based on data from Swiss repo market.
• It has negligible counterparty and liquidity risk.
• It is calculated on concluded transactions and binding quotes posted on a regulated trading platform.
• It uses a quote filter to minimize manipulation.
• It has a rule based calculation in accordance with index regulations, which are open to public.
• The SARON index can be obtained via all standard data vendors or directly from SIX. Historical data is available free of charge.
• It is compliant with international benchmark standards (IOSCO).
• The clearing of SARON based swaps is offered by major clearing houses.

The following are some other facts about SARON.

• ISIN: CH0049613687
• Bloomberg Id: SSARON
• Reuters Id: SARON.S
• Definition: Volume-weighted average interest rate
• Fixing time: 12pm, 4pm and 6pm
• Clearing: Eurex and LCH
• Introduction: 25th Aug 2009
• Publication start: Daily at 8:30am
• Publication interval: Every 10 minutes

Tokyo Overnight Average Rate (TONAR)

TONAR is the weighted average of unsecured overnight JPY call rates in Japan. It is computed by Bank of Japan and the provisional rate is published by 5:15 pm Japanese Standard Time (JST) and by 6:15 pm JST on the last business day of the month, and the final rate by 10:00 am JST on the next day. It is rounded to three decimal places and has Actual/365 day count basis. The Bank of Japan influences TONAR with open market operations so as to align it with its policy rate.

Euro Short-Term Rate (ESTER)

In September 2017 the ECB announced that its Governing council had decided to develop a euro overnight interest rate on the basis of data already available to the Euro system. The rate decided by them is Euro Short-Term Rate (ESTER). The ESTER will complement existing benchmark rates produced by the private sector and will serve as a backstop reference rate.

The European Central Bank (ECB) is the administrator of ESTER and has the overall responsibility of providing the rate.

ESTER is a rate which reflects the wholesale euro unsecured overnight borrowing costs of euro area banks. The rate is published for each TARGET 2 business day based on transactions concluded and settled on previous day (reporting date T) with maturity of T+1 and which are deemed to be executed at arm’s length and thereby reflect market rates in an unbiased way.

The following are some of the features of ESTER.

• It is based on unsecured overnight borrowing among banks.
• Loans of over Euro 1 million is considered.
• The ECB publishes ESTER with three decimal places no later than 09:00 CET on the next TARGET 2 business day.

ESTER is calculated for each TARGET 2 day as a volume-weighted trimmed mean rounded to the third decimal. The volume weighted trimmed mean is calculated by:

• Ordering transactions from the lowest rate to the highest rate
• Aggregating the transactions occurring at each rate level
• Removing the top and bottom 25% in volume terms; and
• Calculating the mean of the remaining 50% of the volume-weighted distribution of rates.

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