Hi all,
Benchmark interest rates serve as a fundamental component within the global financial markets, playing a pivotal role in the pricing and hedging of interest rates and associated risks. The London Interbank Offered Rate (LIBOR) was among the most widely utilized benchmark interest rates and served as a reference point for contracts valued in trillions of dollars across various global currencies.
In 2012, an international investigation into LIBOR revealed a widespread plot by multiple banks to manipulate these interest rates for profit, starting as far back as 2003. Following this scandal, a comprehensive overhaul of the process used to determine Interbank Offered Rates (IBORs) was undertaken. EU Benchmarks Regulation (BMR) has been coming into force since January 2022, resulting in increased regulatory control to actively prevent any new manipulation attempts. Consequently, some interbank reference rates like EURIBOR (Euro Interbank Offered Rate) have reviewed their calculation methodology to respond to the requirements of the new regulation, while others like EONIA and LIBOR were discontinued and replaced by new references.
The far-reaching implications of this shift impacted numerous entities, ranging from corporate entities relying on IBOR-based debt funding to those exposed to hedged debt, both fixed and floating, with derivatives referencing an IBOR. The effects of the IBOR replacement extend across multiple domains, including risk management, legal considerations, information technology, and financial reporting.
The regulatory imperative to navigate the “LIBOR switch” prompted the exploration of dependable alternatives in the form of Alternative Reference Rates (ARRs), focusing on Risk-Free Rates (RFRs) or near Risk-Free Rates based on overnight funding transactions. Benchmark fallbacks, such as AONIA for the Australian dollar, CORRA for the Canadian dollar, €STR for the euro, HONIA for the Hong Kong dollar, SARON for the Swiss franc, SOFR for the US dollar, SONIA for sterling, and TONA for the yen, come into play if the relevant benchmark becomes unavailable while market participants still maintain exposure to that rate.
Inherent structural disparities exist between IBORs and ARRs. While IBORs offer multiple tenors and are commonly applied to forward-looking terms of 1 month, 3 months, and 6 months, ARRs function as overnight rates with a backward-looking perspective. Adjustments to ARRs became necessary to ensure that contracts originally referencing an IBOR continue to align with the original objectives of counterparties once a fallback takes effect. Following industry consultations, the ARRs are now compounded over the relevant IBOR period, and a spread adjustment is incorporated into the compounded rate.
The transition from IBOR rates to ARRs presents a challenge in managing its impact on quantitative models designed for pricing IBOR-linked financial instruments, which traditionally account for forward-looking term rates. Since ARRs replacing IBORs are overnight rates, a term rate must be derived from the overnight rates before being applied in a contract. The preferred method involves utilizing the backward-looking compounded setting-in-arrears rate.
The IBOR transition has other wide-ranging consequences, requiring the development of new curves using RFR across currencies, including interest rate curve bootstrapping, revisiting valuation constructs and theories, and addressing the impact on market data systems and processes due to the introduction of new curves and products, among other considerations.
More specifically, this evolution induces several implications on rate curves and product pricing in LexiFi Apropos, and we have been very proactive internally in helping our clients configure pricing in an efficient and easy manner.
How did LexiFi handle the transition from IBOR to Risk-Free Rates or nearly Risk-Free Rates (RFRs)?
If you are a LexiFi Market Data client, you already know that you have access to the new overnight rates in the LexiFi Market Data source.
Instead of selecting IBOR curves, the pricing section allows you to expand the model and select overnight rates in Multi Curve mode. It is then possible to have access to all RFR curves through LexiFi Market Data and choose the right RFR. When the RFR is selected, SOFR for instance, it is possible to proceed to the pricing by using the Tagged Curve functionality, choosing the right currency (USD in this case) and entering the tag (SOFR).
The use of Market Data can be quite technical sometimes, as it entails the use of a specific Market Data Transformations configuration for each product type, or pricing profile. It’s obviously helpful for temporary use but it is not scalable.
So, we’ve gone even further…
To avoid the hassle of configuring a tagged curve for each product before pricing, LexiFi’s team of experts developed a new feature that allows users to configure a curve once and for all in Static Data by adding a list of global tags per currency.
As shown in the demo below, the configuration process starts by creating (for a chosen currency, here USD) the tags that will be used, defined by order of priority:
- Overnight (SOFR for example)
- Built curve (other than Overnight, SWAPs for instance, corresponding to other tenors 3M, 6M, these are pre-built curves in Refinitiv)
- Empty field (Raw market data, data already available. Curve building by LexiFi. Last resort if the tenor is neither in Overnight nor Built Curve).
Thanks to this configuration, the tagged curve created in Static Data will then appear in data “Market Data selection and transformation” and can be used for pricing by selecting overnight or classical in the multi curve option.
Because we defined the Overnight Rate tenor as the main tenor, Classical or Overnight selection will provide exactly the same price as a result of the tagged curve configuration process in Static Data, whereas if the product is discounted with Libor 1M for example, the price will be different, as shown in the demo below.
Interest rate curve management
The transition from IBOR-based curves to interest rate curves linked to alternative rates has necessitated a shift in the projection/discount interest rate curve. The construction of these interest rate curves relies heavily on the availability of liquid underlying instruments. In the calibration of interest rate curves, new products have come into play, such as the use of SOFR futures for calibrating the SOFR curve, given their high liquidity and prevalence in the short to medium-term market.
The methodology for calibrating other Alternative Reference Rate (ARR) curves varies, and it is expected to evolve as the market undergoes further changes post-transition. In the current landscape, with both “old” and “new” LIBOR rates coexisting, effective multi-curve management becomes imperative. LexiFi offers a solution that addresses the complexities arising from this coexistence, providing a platform that facilitates the management of both “old” and “new” rates in the market.
“The team at LexiFi played a crucial role in the successful IBOR transition that affected several of our complex structured products at CIC Singapore. Their continuous support, coupled with timely new developments allowing us to configure overnight curves and price products pegged to RFR effortlessly showcases the team’s adaptability and efficiency in addressing complex financial products in an ever-evolving environment.”
Jean-Christophe Renaud, Head of Interest Rates and Structuring, CIC Asia.
What to expect next?
As compound overnight rates are slowly becoming the new norm in terms of rate references, our team of experts is already considering the possibility of creating “custom pricers” that would allow users to perform complex pricings in a single step…to be continued!
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