Last week, I have introduced reference rates, their usage in financial industry, existing loopholes, attempted manipulation and proposed recommendations by FSB (with OSSG) to revamp these reference rates in order to make them robust and transparent (http://www.theotcspace.com/2014/10/29/reference-rates-upgraded-all-new-avatars-part-i-3). In this article (Part 2 of 3) I explain about these recommendations in detail and also the advantages of implementing them.

Restoring integrity of IBORs

In order to restore the integrity of these benchmark rates, the Financial Stability Board (FSB) established a high-level Official Sector Steering Group (OSSG) of regulators and central banks to review the existing reference interest rate and examine the feasibility and viability of adopting additional reference rates and potential transition issues arising while adopting these new reference rates.

International Organization of Securities Commissions (IOSCO) has published the standards for financial benchmark rates which the FSB and OSSG have decided to adopt.

Key Standards for Reference Rates are: 

• they should be robust in the face of market dislocation
• they should be calculated based on actual transactions data
• they should command confidence that they remain resilient in times of stress
• they should minimize the ability to manipulate the markets

To bring in these standards, FSB and OSSG have suggested the following principles to be incorporated:

          1. Upgrade IBORs to IBORs+

          2. Introduce (Near) Risk Free Rates

The OSSG formed five currency subgroups –

• Euro
• British Pound
• Swiss Franc
• U.S. Dollar
• Japanese Yen

– to consider and make recommendations, taking into account the market structure, institutions, legal and regulatory framework within each home currency area.

In order to revamp the reference rates, it is intended to consider both strengthening existing interest rate benchmarks and also identifying suitable alternative reference rates along with issues that would arise in transitioning to these alternatives. Hence, to examine the feasibility and viability of adopting additional reference rates and potential transition issues arising from adopting these new rates, the OSSG has formed Market Participants Group.

Implementation of these principles ensures that financial benchmarks meet high quality standards of governance, integrity, methodology, quality and accountability which are necessary to address the identified problems and to command the confidence of users.

Reference Rates upgraded to all new Avatars

The two major measures taken to revamp IBORs are:

1. Introduce new reference rates and encourage market participants to use these rates

2. Use transactions data to calculate current IBORs (to be renamed as IBORs+)

Risk free or near risk free Rates

The reference rates can be broadly classified into two basic types:

1. Risk-free or near risk-free rate

2. Bank credit risk rate

Reference rates such as the IBORs that are based on unsecured interbank markets reflect a premium for the credit risk of their contributing banks as well as potential term, liquidity, and funding premium.

However, rates based on secured borrowing markets or for unsecured borrowing by sovereigns with little default risk would not contain this type of credit risk premium, and to the extent that they were based on more liquid markets, their liquidity premium would also likely be smaller. These rates would be credit risk-free or nearly so.

Ideally, a credit risk-free or nearly risk-free rate would make sense for many derivatives transactions. In some currencies, derivatives referencing these rates have been available for some time, but markets in these instruments are currently overshadowed by IBOR instruments because of the depth and liquidity in those markets. Various risk-free rates include term OIS rates, compounded overnight interest rates, government bond, policy rates and secured funding rates etc. (refer Appendix B for the list of all proposed alternative reference rates).

There has also been a continued need for a reference rate with bank credit risk especially where there is a need to hedge general bank credit risk such as bank-provided credit products. Because rates with credit risk are likely to continue to be traded, there will be a need for basis markets between them and the risk-free rates that may develop in order to allow market participants to properly hedge their risks.

Advantages of risk free or near risk free Rates

Having a range of reference interest rates might offer more appropriate options that better fit the needs of heterogeneous market participants. A market convention with a range of reference rates increases flexibility for users to choose the rate that best fits their economic needs, e.g., a nearly risk-free rate for many derivatives and a rate with credit risk for bank lending products.

With respect to derivatives contracts, in terms of the economic exposures to which the counterparties would ideally be exposed, many transactions do not need a reference rate that includes bank credit risk. From a systemic perspective, having such a large stock of contracts settle on a rate based on a relatively small market creates undesirable incentive problems. Hence, shifting a material proportion of derivative transactions to a risk-free rate would reduce the incentive to manipulate rates that include bank credit risk and would reduce the risks to bank safety and soundness and to overall financial stability.

Upgrading IBORs to IBORs+

Currently IBORs are calculated based on the rates reported/submitted by the prime banks to their authorities. This gives an incentive to banks to manipulate the rates as per their needs (as in case of LIBOR scandal).

Hence, in order to prevent banks from utilizing this incentive more emphasis has been laid on transition to reference rates which are anchored in transactions. More precisely, reference rates should be based exclusively in actual transactions. In some cases, sufficient transactions might not be available for calculating IBORs+. When the conditions in the local market do not allow pure transaction rates, authorities should work with and guide the private sector to promote rates which are derived on a waterfall of different data types:

1. Transactions in underlying market (1st Priority)
2. Transactions in related markets (2nd Priority)
3. Committed Quotes (3rd Priority)
4. Submissions from panel banks (last Priority)

Advantages of IBORs+

IBORs calculated based on the transaction data gives the actual picture of correct market activities taking place. As the transaction data is subject to be audited, there is no scope for banks to rig/manipulate these reference rates. Hence, with the robust and transparent reference rates being used in the market, there is less scope for market manipulation.

In my next article (last one) I shall bring in the disadvantages and hiccups in adopting these recommendations along with various measures which the authorities need to take in order to boost market participants to use these recommendations if adopted. Also stay tuned to know what the market participants think about these recommendations and also what alternate (Near) Risk Free Rates are proposed to be used as Reference Benchmark Rates.

Till then, Stay Tuned!!!