Rival financial data companies competing to become the dominant provider of alternatives benchmark interest rates to Libor are working on the assumption that the Bank of England is expecting operational versions of their forward-looking risk-free rates to be available by the first quarter of next year.
Several providers launched their prototype alternatives to the London Interbank Offered Rate, or Libor, in the summer, and the BoE has advised that these new rates be tested for six months.
"We were thinking of producing a fully operational rate by the end of the year, and still aim to, but I think the BoE is thinking a bit longer than that, maybe the end of first quarter next year. The BoE said they expect to see the beta form of this rate working for several months, which is a bit longer than we were thinking originally," said an executive at one of the companies working on a prototype rate who declined to be named because of concerns around commercial sensitivity.
The BoE declined to comment but the regulator has made it clear to providers that it is in everyone's interests that the new rates are robust, so the current phase of beta testing is important to ensure market participants have confidence in them.
Regulators have set a deadline of the end of 2021 for when Libor is likely to be phased out but a number of elements aimed at encouraging switching from it have been pushed back in the face of the pandemic. For instance, the BoE said it will delay to April 2021 from October 2020 plans to increase so-called haircuts, which are applied to banks using Libor-linked collateral to borrow, to incentivize them to switch to the regulators' favored alternative risk-free rates. It has also extended the deadline for banks to keep issuing loans tied to Libor to April 2021 from October 2020.
Leading financial information suppliers Refinitiv US Holdings Inc., London Stock Exchange Group PLC, and Intercontinental Exchange Inc. this summer produced prototype sterling forward-looking risk-free interest rates as an alternative to Libor, which is used to underpin trillions of dollars of transactions worldwide. IHS Markit Ltd. is also working on its version of a term sterling overnight index average, or Sonia rate. All such providers aim to win business from current Libor users who will use the new rates for a fee.
A panel of banks set Libor and it is based on the cost of unsecured borrowing between lenders for a specific period, usually one, three, or six months, along with the panel's so-called expert judgment. However, since it provides an interest rate for months in advance, it remains popular even though banks were fined billions of dollars and traders jailed in recent years for manipulating the rate in their favor.
As a result, support for Libor is set to be withdrawn and the U.K.'s Financial Conduct Authority, which regulates Libor, has said that the panel of banks that currently submit rates required to calculate Libor will no longer be compelled to do so after 2021. Regulators want banks and investors to use rates that more closely reflect active markets. These overnight risk-free rates provide a theoretical rate of return on an investment with zero risk. They include Sonia, published by the Bank of England. This was set in arrears up until the launch of the forward-looking prototypes.
Refinitiv's new rate, launched in July, was initially available in one, three, and six month tenors but on Sept. 1 it launched a 12-month version of its forward-looking risk-free benchmark interest rate joining rival LSEG's FTSE Russell in providing the option. It is intending to have a fully commercial version of the rate ready by the end of the year.
"We see this as a positive sign that we are getting solid engagement from customers. They're starting to understand their requirements a little bit better," said Jacob Rank-Broadley, director of regulatory and market propositions at Refinitiv.
However, Rank-Broadley said market participants were still working out how best to use term Sonia rates.
"There is growth in the number of customers who are using the rate and those who are using the rate are coming back. It indicates there is rigorous testing under way in many organisations including the major banks, buy-side firms and the corporates, as well as regulators," said Rank-Broadley.
ICE, too, said its forward-looking rate, also launched in July, was still being evaluated in its testing phase, said Stelios Tselikas, COO at ICE Benchmark Administration.
"We are working hard to raise awareness of the rates and help people understand how they work. The testing phase is very constructive as it allows a two-way flow of information with market participants. It allows users to compare the different rates and see how they work, and this should help build confidence and aid adoption of the rates when they go live for use, post-testing. It also provides an opportunity for users to give us feedback," he said.
Investment banks are supportive of the new rates, as JPMorgan Chase & Co. said, especially since the rates could be a valuable precursor to the production of "synthetic Libor" — a formula-based Libor that does not rely on submissions by panel banks.
"Although we haven't used any of the prototype rates yet as they are not approved for use, we fully support their development as we see them as critical to the transition away from Libor," said a spokesman for the bank.
Attractive to customers
Customer usage of the new rates is expected to grow as the deadline for the end of Libor nears.
"We told the BoE that interest in the rate so far had been fairly limited, but the BoE was not at all perturbed by that, so their view is the nearer we get to deadline, the warmer things will become," said the executive who declined to be named.
Any divergence among each provider's rates is clearly likely to attract customers. Rank-Broadley noted that all rates are currently free of charge so market participants can readily make comparisons.
All rate providers and the regulator are keen to ensure the new rates cannot be manipulated, as Libor has been in the past.
"We made sure we get the optimum window for data collection, that is long enough that it would reduce the risk of it being gamed but that was short enough that it reflected a point in time that an individual trader could execute a trade at and it would be representative of the market at that given point," said Rank-Broadley.