Term RFR use limits; what use are they?
It’s a long time since anyone disputed trade liberalisation as a force for economic good.
Likewise, it’s a long time since anyone questioned the value of liberalised financial markets in promoting the efficient movement of global capital.
So why are global regulators defining use-case preferences or limits on the use of Term RFRs? Why are lay out hurdles that restrict us?
In this blog I explore this topic and present some suggestions on how to negotiate the use-case minefield that has emerged.
Liberalised markets
It’s a long time since anyone seriously disputed trade liberalisation as a key driver of economic growth. Likewise, it’s a long time since liberalised financial markets were claimed to detract from the efficient allocation of capital and resources across economies.
Financial markets work best when they’re liberalised. For one thing, risk transfer and risk dispersion take place more efficiently when there are deep pools of market activity. For another, pricing transparency is advanced in markets where participation is not discouraged; and these are both aspects of what the Big Bang was ultimately all about.
Step forward to the 2020’s and the freedom of a truly ubiquitous financial benchmark is making way for a collection of replacement rates, including a serious suite of new term rates that we’ve written about before, (see here, here, and here). What seems somewhat at odds with liberalisation is that these rates appear to be emerging somewhat less free depending on the jurisdiction they are based.
We notice that all of the Term-RFR variants outside Japan are accompanied by regulator preferences and licencing restrictions that are likely to govern how they’re used. We’re not convinced these are helpful, but we can’t deny their existence.
Regulatory Pressures
Paraphrasing key quotes and/or summarising measures from across the regulatory landscape, the use-freedom of term rates appears to have been deliberately crimped:
They (term rates) are by their nature a derivative of RFR markets. Because these RFR-derived term rates would be based on derivatives markets, their robustness will depend on derivatives market liquidity. Activity in these derivative markets may, however, be relatively thin and vary significantly with market conditions, including on expectations about central bank policy changes.
Moving the bulk of current exposures referencing term IBOR benchmarks that are not sufficiently anchored in transactions to alternative term rates that also suffer from less liquid underlying markets would not reduce risks and vulnerabilities in the financial system. Therefore, because the FSB does not expect such RFR-derived term rates to be as robust as the overnight RFRs themselves, they should be used only where necessary.
Bank of England Term-SONIA
In January 2020, the Sterling Working Group recommended a limited use of Term SONIA.
If use of a TSRR became widespread, there is a risk of reintroducing structural vulnerabilities similar to those associated with LIBOR. While several hundred $trillion worth of financial contracts reference LIBOR, the underlying market determining the rate was comparatively smaller.
These risks can be avoided by limiting the use of TSRRs.
The areas identified as being potentially appropriate for Term SONIA uses were:
smaller corporate, wealth and retail clients. However, the Task Force noted that other rates such as fixed rates or the overnight Bank Rate (see further below) should be considered as well;
trade and working capital financing, which use a term rate or equivalent to calculate forward discounted cash flows to price the value of assets in the future;
export finance and emerging markets, where the customer typically requires more time to arrange and make payments; and
Islamic financing which can pay variable rates of return, so long as the variable element is predetermined.
FMSB Standard on use of Term SONIA reference rates
Noting that FMSB members agree to abide by FMSB Standards in their business practices, we note the wide reach of this standard in UK term rate use.
Term SONIA is derived from executable quotes for SONIA-based interest rate swaps. Its robustness therefore depends on the liquidity in such swap markets, so it is in the interest of all potential users of Term SONIA for those markets to remain primarily based on overnight SONIA. If the volume of swaps data available is not consistently as large as in overnight funding markets, then Term SONIA cannot be as robust as overnight SONIA.
The standard then loosely defines possible use cases across lending, bonds, and derivative markets, repeatedly imploring market participants to assess use case limits “in a manner consistent with this Standard.”
It makes little attempt to be prescriptive.
FED ARRC Term-SOFR
Use of the SOFR Term Rate should be in proportion to the depth of transactions in the underlying derivatives market and should not materially detract from volumes in the underlying SOFR-linked derivatives transactions that are relied upon to construct the SOFR Term Rate itself over time and as the market evolves. Like all the ARRC best practices, the extent to which any market participant decides to implement or adopt any benchmark rate is voluntary.
On 29 July 2021, ARRC formally recommended CME Group’s forward-looking SOFR term rates.
ARRC did not impose similar restrictions on the use of Term SOFR as seen with Term SONIA, instead leaving CME Licencing rules to govern use limits (see below).
CME Licencing CME Term-SOFR
The CME’s licencing regime maintains three categories of use (described within Use Licences) which combined, broadly conforms to the ARRC’s Best Practices guide:
Category 1 – Use in Cash Market Financial Products;
Category 2 – Use in OTC Derivative Products; and
Category 3 – Use in Treasury, Risk & Transaction Admin Services.
However, Term-SOPFR’s free use in a traditional liberal OTC setting is not assured, and this is crucial:
Use of CME Term SOFR Reference Rates only as a reference in an OTC Derivative Product that is tied or linked to a licensee and End User hedging against exposure from one or more Cash Market Financial Products that references the same CME Term SOFR Reference Rate.
We read this as a serious control, likely to crimp activity.
SNB National Working Group on Swiss Franc Reference Rates
Imposing a complete term-rate limit, the SNB considered it unlikely that a robust SARON term rate could ever be feasible and recommended that market participants use compounded SARON wherever possible.
Working Group on Euro Risk Free Rates (ECB / ESMA)
While the joint working group recommended a forward-looking term rate for €STR, derivative markets based on €STR are not yet sufficiently liquid to permit the endorsement of a forward-looking term rate, despite having announced an RFP process in July 2019. No target date for the publishing of such a term rate exists at this stage.
To an extent this is less problematic in EUR, since Euribor continues to be published.
TORF becomes the outlier
Somewhat surprisingly, Japan has taken the liberal path to term-rates.
In Tokyo, the Tokyo Term Risk Free Rate (TORF) is published by Quick Corp. Since May 2020, this has been based on uncollateralised overnight call rate which calculates the interest rate from JPY Overnight Index Swap (OIS) transaction data.
Unlike other major jurisdictions, neither Quick nor the Bank of Japan has (so far) placed any limitation on TORF’s use, which would appear to make Japanese financial markets the most liberalised on the planet for Term-RFR rates.
So, why limits?
Our reading as to why a collection of use-limits has unfolded is quite simple; the robustness of new benchmarks is of paramount importance to a regulatory family bruised by the fact that LIBOR robustness fell so far. They don’t wish to see a repeat.
What’s also clear is that the robustness of Term-RFR is always and everywhere dependent on the derivatives market liquidity of related OIS and RFR futures markets, which are implied-forward RFR markets. The proper functioning of the term rate system therefore depends on the viability of these implied forwards, which themselves must be kept robust.
It is not hard to imagine what could happen if a particular Term-RFR market started to cannibalise the liquidity of its own underlying rate.
We view this as a particularly unlikely scenario since OIS and RFR-Futures markets are developing and have almost limitless liquidity potential (they are implied, not physically supplied). We also see Term-RFR fallbacks as an important risk-mitigant. Nonetheless, we have to acknowledge that the regulators have a serious point to make, and they appear to have made it via their use-case preferences.
Practical Implications
While expounding its use-case preferences for Term-SOFR, the FED’s ARRC noted that: “each market participant should make its own independent evaluation and decision about whether or to what extent any recommendation is adopted.” Which seemed to throw the use-case ball into the welcoming arms of individual firms, but with the CME licencing regime taking the shape that it has the ARRC’s use-case wish-list has emerged more practically within the licence.
This effectively swamps all sense of “independent evaluation and decision” (making) on the USD term RFR scene.
Conceding that participants are generally still grappling with the wider ramifications of LIBOR cessation, and the uncertain new world of compound or simple RFR’s, the use of term rates is patchy. Nonetheless, firms should start considering the use-case environment quite carefully to:
Ensure that use-case controls prevent dealing activity that contravenes regulator or industry preferences, and/or licencing requirements.
Establish a rules-based exceptions mechanism for allowance of Term-RFR use where use is warranted, and processes that document and track artefacts where use-case exemptions are approved.
Understand the peculiar reset risk that exists where Term-RFR’s are hedged via traditional OIS products.
Define and tag Term-RFR products as such, including within risk systems where unexpected basis and reset risk can emerge (between Term-RFR and traditional OIS hedges).
Ensure key staff understand term rates, their role in finance, their use-case limits, particularly where such staff are customer facing.
At Martialis we have immersed ourselves in the complexities of RFR’s and the conundrums associated with Term-RFR’s. We are well placed to guide firms as they negotiate the path through the new rates, associated products, and the various use-case minefields.