IBOR transition: fallback solutions in illiquid markets
At the end of this year, the LIBOR we currently know will be discontinued. For some currencies, the calculation methodology will be adjusted, while others will move to a brand new or alternative risk-free rate (RFR). This also holds for the dollar LIBOR, which will be replaced by the Secured Overnight Financing Rate (SOFR). However, some currencies use the USD LIBOR as a basis for their current reference rates, mainly due to liquidity concerns. Therefore, these FX implied rates face an additional challenge.
Next to determining a new reference rate, a smooth market transition must be ensured to generate sufficient liquidity. This article focuses on three currencies and how their reference rates administrators plan to deal with the challenge at hand.
Table 1: Overview of FX implied rates and alternative rates
Singapore Dollar (SGD)
The SGD Swap Offer rate (SOR) is calculated from actual transactions in the USD/SGD FX swap market and based on the USD LIBOR.
In August 2019, the Association of Banks in Singapore identified the Singapore Overnight Rate Average (SORA) as the alternative reference rate. Not only has this benchmark existed since 2005, but its market is also liquid and robust. The unsecured rate will form the basis for longer maturities by the means of a compounding average. The Steering Committee for SOR Transition to SORA (SC-STS) published a roadmap to promote the development of a SORA-based market in loans, bonds and derivatives. The most important steps to developing such a market, such as launching central clearing for SORA derivatives, issuing derivatives, and having SORA-based pilot products, were already taken in 2020. However, a deadline for the discontinuation of SOR-linked products still needs to be formulated. Additionally, new products referencing SOR are still being issued, which impedes the development of SORA markets.
The Association of Banks in Singapore and the International Swaps and Derivatives Association (ISDA) published a factsheet about the SOR fallback rate. In principle, it relies on the fallback clause for the USD LIBOR, which is essentially the SOFR. However, a spread adjustment is included based on the historical median over a five-year lookback period. The fallback solution will probably only be available for three years, after which it is expected that markets have transitioned almost entirely to SORA.
Thai Baht (THB)
The Thai Baht Interest Rate Fixing (THBFIX) is obtained by synthetically borrowing at the USD LIBOR for the respective maturities and using the USD/THB spot rate or FX swaps to generate a THB denominated rate. Due to the cessation of the USD LIBOR, the Bank of Thailand decided in April 2020 to discontinue the publication of the THBFIX by the end of 2021.
As an alternative, the Bank of Thailand launched the Thai Overnight Repurchase Rate (THOR) in April 2020. The THOR Average for the one-, three- and six-month tenors are obtained by compounding THOR’s daily values. Consequently, longer maturity rates are published in arrears. The Bank of Thailand set specific transition milestones to ensure a gradual shift from one reference rate to another. By the end of Q1 2021, financial institutions should be ready to offer interbank interest rate swaps referencing THOR. Furthermore, it is prohibited to issue new loan products referencing THBFIX after Q2 2021 and all banking systems must be ready by then to accommodate compound setting in arrears.
For legacy contracts that are linked to the THBFIX, the Bank of Thailand started releasing the fallback rate (also called THBFIX). It is likewise a synthetically created rate, however its basis is the SOFR and the forward points are constructed by compounding in arrears. It is estimated that the fallback rate is only required for three years. Afterwards, market participants should have amended or adjusted their current products to accommodate THOR.
Norwegian Krone (NOK)
Until January 2020, the Norwegian Interbank Offer Rate (NIBOR) was derived from the USD LIBOR and adjusted for interest rate differentials between the domestic and foreign currencies. Since January 2020, the methodology has been amended to comply with the EU benchmark regulation (BMR). The six panel banks must quote committing sales prices from certificates of deposits or commercial papers. Hence, the NIBOR already became independent of foreign rates and the administrator keeps the option open to cease or continue calculating the rate.
However, the Norwegian money market is a special instance, as it does not yet have a publicly administered overnight rate. With the IBOR reform, Norges Bank (Norway’s central bank) wants to establish an overnight index swap (OIS) market. This was welcomed by all consulted market participants, mainly consisting of the leading Scandinavian banks. After much consideration, Norges Bank introduced the Norwegian Overnight Weighted Average (NOWA), an unsecured rate between banks that are active in the Norwegian overnight market (except Norges Bank itself). A dedicated working group is currently pursuing the final steps before the OIS market’s launch in Q3 2021. These steps entail establishing central clearing of derivatives referencing NOWA, enabling NOK OIS on trading platforms such as Bloomberg, and generating liquidity by gathering support from Scandinavian banks active in the NOK interest rate swap markets.
Even though NIBOR is the most widely used reference rate in Norway, a second working group evaluated fallback solutions in case of a NIBOR cessation. After all, the ISDA will launch a ‘protocol’ regarding the incorporation of IBOR fallbacks. The working group recommended citing a daily compounded NOWA as replacement in the respective ISDA documentation. Additionally, a spread-adjustment factor should be involved consisting of the median difference between the NOWA and the relevant NIBOR tenor for the past five years. This approach is similar in nature compared to the Singaporean fallback approach. However, the working group notes that there is currently no indication of a NIBOR termination.
Local Solution – Global Trends
By briefly analyzing these three examples, several trends can be observed. First, domestic interest rate markets seek to become independent of foreign quotes. While liquidity and reliability are a major concern, it is an understandable step forward with respect to the valuation of local assets. Second, the new RFRs are based on overnight rates. Term structures will be constructed by compounding the daily rates in arrears. This implies that the financial world and the financial systems will need to adjust to accommodate new calculation methods. Finally, the fallback clauses for FX implied curves seem to align to a high degree, which are still relying on a US curve (SOFR) but almost surely provides sufficient liquidity.
It remains to be seen how the markets will adapt the proposed rates. It is important that these rates are liquid, robust, and reliable because ultimately the market players will form a judgement whether they have sufficient trust in the new reference rates. In the case of any exposure, the developments in minor IBORs should therefore not be overlooked to avoid negative impacts on cash flows or valuations once the transition is completed.