BIS Paper Presents Alternative to Forward-looking Term Rates

Many banks have adopted a “wait and see” approach to the LIBOR phase-out, waiting to forward-looking term rates based on RFR derivatives to become available.

A new BIS working paper has proposed a solution for market participants, primarily banks, who are in need of forward-looking term rates to migrate cash products from LIBOR to alternative rates.

The issue has been brought into focus primarily in the cash market, where the standard for LIBOR-based products has so far been based on quarterly payments, where the interest rate payment is known at the beginning of an interest rate period (i.e. using three-month LIBOR).

By contrast, RFRs (risk-free rates) are overnight rates, which mean the term reference rate is usually known at the end of an interest period (‘in arrears’).

For cash products such as loans, many banks have indicated a preference to know the rate before the start of the interest rate period, i.e a pre-determined rate. This is driven by a range of factors, including the inability of some bank IT systems to handle term rates based on ‘in arrears’ compounding.

As such, many banks have adopted a “wait and see” approach until forward-looking term rates based on RFR derivatives become available. But, because most RFR-based derivatives markets are not yet liquid, and they can become illiquid in crises, the paper argues that forward-looking RFR term rates may not be the ideal solution.

“A cash market waiting for a forward-looking term rate leads to a chicken-and-egg problem, in the sense that it is hard for the derivatives market to become liquid in absence of a deep cash market (and vice versa),” the paper says.

The authors present a model for using past RFRs known at the beginning of an interest rate period to define a pre-determined term rate, described as “a lagged version of the ‘in arrears’ approach”.

This approach, like LIBOR, offers the benefit of predeterminedness that certain participants in cash markets require. And while it may at times create a mismatch to a compounded RFR ‘in arrears’, the paper argues this ‘basis’ can be priced, and therefore managed.

The paper evaluates two practical ways for market participants to reduce the basis. One approach is to use the RFRs of the last period as a term rate and to add an adjustment factor to compensate for the basis.

The second approach – the more promising option – is to reduce the basis by relying on shorter observation periods prior to the interest period when calculating the pre-determined term rate. “In this way, the term rate becomes more responsive, as not the entire past period is used for the calculation,” the paper says.

“For instance, using the RFRs compounded over the week prior to the interest period to determine the interest payments for the next three months, leads to a basis which is low on average and also not too volatile. At the same time, the approach still allows for payments to be on a quarterly basis.”

As the ‘in advance’ term rate already exists and is underpinned by the robust RFRs, usage of the rate in cash contracts may help to accelerate the transition away from IBOR-style benchmarks, it says.

The paper’s analysis relies on empirical data for the effective federal funds rate (EFFR), an overnight rate chosen for its much longer history compared to SOFR, to demonstrate that the volatility by using one week observation periods turns out to be roughly similar as that when using three-month forward-looking rates such as LIBOR or OIS.

The full paper is available here.

The paper was written by Swiss National Bank’s Basil Guggenheim and the BIS’s Andreas Schrimpf.

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