Reference Rates Upgraded to all new Avatars (Part 3 of 3)
The final installment of a series on the re-building of LIBOR
In my last two articles, I have introduced the reference benchmark rates and the proposal from FSB to revamp the existing reference rates (LIBORs, EURIBORs, TIBORs etc. collectively termed as IBORs) to make them more robust and transparent ((http://www.theotcspace.com/2014/10/29/reference-rates-upgraded-all-new-avatars-part-i-3). The introduction of new reference rates benchmarks ((Near) Risk Free Rates) and upgrading of IBORs to IBORs+ (using transactions data instead of quotes data) are some recommendations introduced by FSB. The Part 2 of this article (http://www.theotcspace.com/2014/11/08/article-reference-rates-upgraded-all-new-avatars-part-2-3) talks about these recommendations in detail along with the advantages of implementating them.
In this article (Final Part), I shall talk about the challenges/hiccups in adopting these recommendations, possible approach by authorities to smoothen these challenges, and market participants response to these recommendations.
Hiccups to adopt Risk Free Rates
Though adopting the risk free rates has various benefits and also protects the possible manipulation of existing IBORs, there are some roadblocks to market participants in adopting these new alternative rates. In particular, the markets in products that reference the IBORs are deep and liquid, and hence easy to transact in. In addition, the current nature of these reference rates provides flexible hedging opportunities.
Alternate risk free reference rates, even if they are better suited to the needs of market participants, are not liquid enough to be as widely used as would be desirable. Moreover, there is an increased flexibility in creating more customized derivative contracts based on these new reference rates thereby:
reducing the number of standard contracts in the market
reducing the liquidity in derivatives contracts
increasing instability to financial system in case of financial distress
requiring enhanced monitoring of these contracts by regulators
The lack of movement by market participants to a multiple reference rate solution suggests agency problems, externalities or coordination problems.
Hiccups to use transaction data
The main hindrance in transforming straight away to IBORs+ is the insufficient transactions data for some currencies and tenors and high degree of dependence on market liquidity, market depth, data sufficiency and varied level of transactions by currency.
In pursuing the objective of moving to transactions-based rates, transition risks and costs are also major factors in facilitating the transformation to IBORs+. These risks and costs can include legal risks arising from litigation and contract frustration and increased hedging costs resulting from reduced liquidity in instruments referencing the alternative rate or from the greater volatility that may naturally occur in more transactions-based reference rates.
Key Challenges to upgrade reference rates
Though introducing the two major measures of creating risk-free rates and upgrading IBORs to IBORs+ for having robust reference rates, there are several challenges in adopting these changes.
Some of the concerns identified are:
Reduced Market Liquidity: Firstly, market liquidity is improved when the use of benchmarks is highly concentrated and overall market liquidity may decline if the market is fragmented across multiple reference rates. The impact of this type of fragmentation could be greater in jurisdictions where markets are smaller in overall size.
Increased costs and complexity: Higher frictional hedging risks and costs, risk transfer synergies amongst a wide range of markets, complex back office operations, valuation complexity for risk, capital and tax purposes are some major concerns in shifting to these changes in.
Need for Basis Markets: Basis markets between the different rates would also need to be developed in order to allow market participants to hedge risks incurred as their assets and liabilities may reference different rates.
Smoothing these challenges
The transition to an entirely new rate for some products (derivatives) should also take transition costs into consideration. Such costs may be minimized by encouraging a substantial proportion of new contracts to be written on the new rate. By encouraging large numbers of contracts to reference the new rate, liquidity in the new rate may increase, which would reduce transaction costs. Once a critical mass of contracts using the new rate has been achieved, some market participants may wish to convert legacy contracts to the new rate. Such a conversion should be incentivized if it can be achieved at a low cost.
There is a strong importance of working to strengthen existing IBORs by underpinning them with a greater amount of transactions data and introducing new risk free/near risk free rates in the market. However, many financial transactions may be better served by a reference rates incorporating credit risk (IBORs) and moreover the difficulties in transitioning legacy contracts strongly argue for an approach that seeks to preserve the continuity of existing contracts. This paradox of requiring upgraded IBORs but not transforming them completely to IBORs+ and requiring new reference rates but not reducing the dependency on existing reference rates would prevail in the market.
Market Participants response to these recommendations
Proposed Alternate Benchmark Rates (Near Risk Free Rates)
Implementing the recommendations set by OSSG and FSB, reduces the possible manipulation of reference rates by making them more robust and transparent. Using reference rates which are calculated based on actual transactions data increases transparency and prevents manipulation as these rates would be subjected to audit. Also, introducing (near) risk free rates gives more opportunities to market participants to choose the reference rates which better suit their needs. However, adopting these recommendations is not as simple as it seems to be. There is a possibility of reduced market liquidity and increased costs in adopting these changes. There is a need for basis market to increase liquidity between risk free rates market and credit risk market. There is an uncertainty in the amount of time it takes for this basis market to mature. Moreover, availability of transactions data is a key concern as all the panel banks might not actually borrow money for all maturities in interbank money market.
Hence, it is a challenging task for the authorities to implement these recommendations without having negative impacts on the current system. Incorporating these recommendations by providing incentives, introducing benchmarks with alternative reference rates and encouraging market participants to use these benchmarks can induce the proposed changes smoothly in the market.
Financial Business Analyst,
Genpact Headstrong Capital Markets.