LIBOR transition in Switzerland: - PowerPoint Presentation

Slide1

LIBOR transition in Switzerland:Starter pack

National Working Group on Swiss Franc Reference Rates

Version: February 2019

About this packThis pack is designed to inform readers about the transition from CHF LIBOR to SARON. For instance, it may be used when engaging with internal and external stakeholders on the topic.It was developed by the National Working Group on Swiss Franc Reference Rates

(NWG), which is the key forum for considering proposals to reform reference interest rates in Switzerland. Further details about the NWG can be found on Slide 12.

Questions and suggestions will be gratefully received and may be sent to

nwg@snb.ch.

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AgendaImportance of and issues with LIBORWhat is SARON?SARON as alternative to CHF LIBOR

Compounded SARON as term rate alternative to LIBOR

Current challenges

5.1. Options for using a compounded SARON

5.2. Enhancing contractual robustness

5.3. Promoting operational readiness

5.4. Development of a SARON ecosystemNWG on Swiss Franc Reference RatesNWG milestonesInternational overview of reform initiativesAdditional information and links

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1. Importance of and issues with LIBOR4

What is LIBOR and why is it important?

The London Interbank Offered Rate (LIBOR) is a measure of the average rate at which banks are willing to borrow wholesale unsecured funds. It is administered by the ICE Benchmark Administration and is calculated as a trimmed mean of submissions from selected

panel banks

. It is published in five currencies (USD, GBP, EUR, CHF, JPY) and a range of tenors (ON/SN, 1W, 1M, 2M, 3M, 6M, 12M).

LIBOR is the most widely used interest rate benchmark and serves as a price reference for a broad range of financial instruments, such as loans, bonds, and derivatives (Figure 1). The volume of outstanding financial contracts that reference LIBOR is estimated at approx. USD 300

tn globally with approx. USD 6.5 tn in CHF LIBOR (

FSB

, 2014).

Figure 2: proportion of panel bank submissions used to calculate LIBOR that are transaction-based, transaction-derived or based on expert judgement (

ICE

, 2018)

What is the problem with LIBOR?

The underlying market of CHF LIBOR is no longer liquid. Activity has shifted from the unsecured to the secured money market since the global financial crisis. As a consequence

, the calculation of CHF LIBOR is almost entirely based on expert judgement instead of actual transactions (Figure 2).Panel banks are uncomfortable about providing submissions based on expert judgement. The Financial Conduct Authority (FCA), the regulatory authority supervising LIBOR’s administrator, has announced that it will neither persuade nor compel banks to participate in LIBOR panels after the end of 2021. LIBOR’s existence beyond 2021 is thus highly uncertain and a transition to alternative reference rates is inevitable.

Figure 1: basis for pricing of loans in CHF (SNB Bank Lending Survey, 2018)

2. What is SARON?5

The

Swiss Average Rate Overnight

(SARON) reflects the conditions for overnight transactions in the secured CHF money market. SARON is administered by SIX

Swiss Exchange (SIX).

SARON is calculated as a volume-weighted average of transactions and binding quotes in the order book of SIX’s electronic trading platform. A filter is used in order to exclude outliers. The methodology, which was developed in coordination with the SNB, is transparent and publicly available.

The overnight segment of the CHF repo market is the most liquid segment of the CHF money market. Figure 3 shows the development of the calculation basis (rate volume) for SARON since 1999.

Figure 3

:

SARON rate volume (

SIX

, 2018)

SARON is

calculated immediately after the market has closed (6 p.m.) with further fixings during the day at 12 noon and 4 p.m.SARON has clear governance structures in place and complies with international benchmark standards. At the beginning of 2017, SIX founded the SRR Index Commission, which periodically reviews all aspects of SARON.

Slide 6 summarises the key characteristics that make SARON a robust and representative CHF benchmark and underpin the NWG’s decision to recommend SARON as the alternative to CHF LIBOR.

3. SARON as alternative to CHF LIBOR6

Representative

Secured overnight money market conditions are

reflected at all times

.

Based on

actual transactions and binding quotes submitted by a set of more than 160 active market participants in the regulated Swiss repo market.Represents by far the most liquid segment of the CHF money market.

Administered

in Switzerland

Established

in 2009

and calculated back to 2000, with

daily fixings.

Administered by SIX, which operates infrastructure for the Swiss financial centre. Complies with international benchmark standards.

Methodology developed in conjunction with SNB; regularly reviewed by an index commission.RobustMethodology is transparent and publicly available.Counterparty default risk is minimized in the repo market and outliers are excluded. Therefore, SARON is resilient in times of market stress.

4. Compounded SARON as term rate alternative to CHF LIBOR7

Difference between contracts linked to 3M LIBOR and compounded SARON

When using a term reference rate such as 3M LIBOR as a benchmark in a financial contract, interest payments are already known at the beginning of the interest period (Figure 4, left-hand side). This type of

forward-looking term rate

reflects the expected level of interest for the next three months and is equivalent to a sequence of

expected

overnight rates.When using compounded SARON as a benchmark in a financial contract, interest payments are the result of daily compounded interest rates (Figure 4, right-hand side). This type of compounded term rate reflects the realised level of interest for the past three months and is equivalent to a sequence of

realised

overnight rates. Whether interest payments are known at the beginning of the interest period depends on how a compounded SARON is applied. It is possible to implement a compounded SARON where interest payments are known at the beginning of the period (compounded SARON in advance).

NWG recommends using compounded SARON as term rate

In order to facilitate the transition away from LIBOR, the NWG has assessed the feasibility of a forward-looking term rate based on SARON derivatives, such as SARON swaps and futures. The NWG believes a robust fixing of a forward-looking term rate based on SARON-derivatives is unlikely to be feasible. It thus

recommends

using a compounded SARON wherever possible.

Compounding is preferred to a simple average, as compounding is the standard convention on the swap market.

Compounded SARON follows 3M LIBOR closely and tends to be relatively predictable (Figure 5). Compared to 3M LIBOR, compounded SARON is less volatile. Additionally, as SARON does not entail a credit spread premium, the rate tends to be lower and more stable in times of market turbulence.Figure 5: development of 3M CHF LIBOR, SARON, 3M SARON compounded ove

r time (Bloomberg, SNB, 2018)

Figure 4

: comparison

of a contract referencing 3M LIBOR vs. compounded SARON

Current challenges5.1 Options for using a compounded SARON8

Different forms of cash flow uncertainty require different solutions

After recommending the use of a compounded SARON as a term alternative to CHF LIBOR, the NWG published specific options on how a compounded SARON could be used as a benchmark in financial contracts, such as loans, mortgages, and capital market instruments. Underlying these options is the question of how best to mitigate

uncertainty about

future

cash flows

– a factor that is inherent in a compounded approach.Broadly, uncertainty regarding future interest payments falls into three categories – and the preferred solution will depend on the type of certainty a market participant requires when it comes to interest payments.

If a market participant has a fundamental aversion to variable future interest payments (i.e. payments that are ex-ante unknown), buying a

fixed-rate

product is the best option. With a fixed-rate product, cash flows for all periods are known from inception and no benchmark is required (cash flow certainty over lifetime of product).

If a floating-rate product is preferred but the next cash flow instalment must be known at the beginning of each interest rate period (as is the case with LIBOR-linked contracts), an

in-advance

option is suitable (cash flow certainty for a single period).

If a floating-rate product is preferred and an interest rate payment known close to the end of a period can be tolerated (e.g. from a cash management perspective), an

in-arrears option is suitable.NWG sets out options for market participants’ considerationThe NWG has proposed several options for using a compounded SARON (Figure 6). First, options for compounded SARON in arrears, of the kind already used in the derivatives market; here, the next interest payment is known a couple of days before the payment is due. Second, options for compounded SARON

in advance; here, the next payment is already known at the beginning of a given interest period.The NWG

recommends

market participants consider and asses these options. Additionally, it recommends that each financial institution defines an action plan with respect to its product strategy.

Figure 6

: overview

of options

for using compounded

SARON (

NWG

, 2019)

Current challenges5.2. Enhancing contractual robustness9

Fallback

provisions as safety net for contracts maturing beyond 2021

Fallback

provisions support contract continuity and enable the conversion of contracts if LIBOR ceases to exist. Existing financial contracts often do not contain

fallback

provisions. The adoption of appropriate fallbacks will help to reduce the risk of market participants finding themselves in disagreement or dispute on rights and obligations attached to LIBOR-referencing contracts.

However,

fallback

provisions are not designed as the primary transition mechanism. They

serve as a safety net in the event that LIBOR ceases to exist and they should not be relied upon. The

smoothest and best way to transition is to reduce exposure to CHF LIBOR before 2021 and conclude new business using SARON.

Efforts to enhance

fallback

provisions for derivatives and loansFor derivatives, the International Swaps and Derivatives Association (ISDA) is working on an amendment to the 2006 ISDA Definitions that will include fallbacks to LIBOR and a protocol to include the amended definitions in existing transactions (Figure 7, top).During summer 2018, ISDA conducted a public consultation in which it assessed how to construct fallback rates from alternative risk-free rates (RFR). In December 2018, ISDA published the results

of the consultation indicating that the development of the fallbacks will be based on a compounded setting in arrears for the RFR, with a historical mean/median approach being applied for the spread adjustment.Loan contracts are less standardized than derivatives and they typically fall under local law. Each institution must therefore implement appropriate

fallback

mechanisms for new contracts, as well as amendments to existing LIBOR-referencing contracts, individually. A proposal for a

draft

fallback

template

has been developed for new retail loan contracts (Figure 7, bottom).

Figure 7

: overview

of

workstreams

on enhancing contractual robustness for derivatives and loans

Current challenges5.3. Promoting operational readiness10

Becoming operationally ready requires a high level of coordination within an institution

LIBOR is embedded in firms’ operating models. Transitioning to alternative rates will affect how contracts are written and priced, risks managed and IT systems operated.

Amending the operating models will require time and substantial resources. It is therefore important for affected institutions to initiate a concrete action plan detailing how they intend to address the challenges presented by the transition.

The NWG has developed a

checklist

to help LIBOR users improve operational readiness ahead of the transition to alternative RFRs.

FINMA guidance on transition away from LIBOR

FINMA has published

guidance

(

Aufsichtsmitteilung

) on the risks involved in transitioning away from LIBOR and has recommended that supervised entities address these challenges in good time. Furthermore, FINMA will be discussing with supervised institutions how to ensure the adequacy of any measures the latter may have taken to monitor, identify and limit transition risks.

Project

managementEnsure senior management awareness and set up internal LIBOR transition project

Products and

contracts

Legacy contracts referencing LIBOR

Quantify exposure to LIBOR across products

Assess contractual terms regarding

fallback

to RFRs

Define transition strategy in order to avoid contract frustration

New contracts referencing LIBOR

Determine adequate

fallback

provisions

Implement

fallback

provisions for existing products and conclude contracts with updated

fallback

language

New contracts referencing alternative RFRs

Develop new products referencing alternative RFRs

Communication

and training

Ensure internal flow of information to all stakeholders

Reach out to counterparties regarding changes to existing contracts

Accounting and

treasury

Operational

requirements

Assess impact on accounting (particularly hedge accounting), as well as valuation and cash flow projections

Assess the impact on taxes

Assess impacted IT systems

Ensure IT systems can handle new products

Engage with software providers and data providers

Current challenges5.4. Development of a SARON ecosystem11

Use of LIBOR in financial products

A range of financial products, such as derivative contracts or floating-rate mortgages, are directly linked to LIBOR.

Equally, LIBOR is used to price and value a large number of contracts (e.g. bonds). This is done using the curve generated by LIBOR-linked derivatives such as swaps and futures (Figure 8). This is particularly pronounced in Switzerland, where the LIBOR-based swap curve plays a very important role, as liquidity in the government bond market is relatively low.

In order to facilitate the transition from LIBOR to SARON, it is important to develop a liquid ecosystem of products linked to SARON, such as futures, swaps, loans, floating-rate notes, etc.

SARON-based derivatives products

The SARON swap market was established in 2017 as a replacement for the TOIS fixing. While the volume of outstanding contracts increased significantly during 2018, it remains significantly below the volume of LIBOR-linked interest rate swaps.

In June 2018, the NWG published a

term sheet

for SARON futures. Since October 2018, SARON futures have been trading on

Eurex

.

SARON-based cash products

To date, there has been no market for cash products based on SARON. Establishing (compounded) SARON as a RFR for cash products would likely increase liquidity in the SARON-based derivatives market as such a development would stimulate demand for hedging.

The NWG is working on identifying various options for using a compounded SARON in cash products such as loans, mortgages, and capital market instruments (see Slide 8).The NWG has assessed the use of SARON for floating-rate notes (FRN) and sees no impediments to issuing SARON FRNs.Figure 8: LIBOR serves as a pricing reference for various financial markets

6. NWG on Swiss Franc Reference Rates12

The NWG is the key forum to foster the transition to SARON and to discuss the latest international

developments. The

NWG is co-chaired by a representative of the private sector and a representative of the Swiss National Bank (SNB

).

The SNB acts as a moderator and runs the technical secretariat.

The NWG will cease to exist once the transition to SARON is materially completed.The NWG was initially established in 2013 to reform the TOIS fixing. Since the successful replacement of the TOIS fixing with SARON, the NWG has been concentrating on the transition from CHF LIBOR to SARON. Two sub-working groups are focusing on the transition away from LIBOR in loan and deposit markets (ToR Sub-NWG L&D) and in derivatives and capital markets (

ToR

Sub-NWG D&C

) respectively (Figure 9).

The NWG includes all relevant stakeholders affected by the LIBOR transition.

It currently comprises representatives of banks, insurance companies, corporates, financial market infrastructure providers, international institutions, public institutions, and stakeholder associations.

The NWG maintains a regular dialogue with other working groups in order to coordinate and exchange information on international reform efforts.

For cross-currency swaps, the NWG engages in the international sub-working group convened by the Alternative Reference Rates Committee.

Figure 9: organizational structure of the NWG

7. NWG milestones13

June 2013

NWG is established to reform TOIS fixing.

January 2016

NWG decides to focus reform efforts on SARON as alternative to TOIS fixing. Between 2013 and 2016, multiple reform efforts with respect to TOIS fixing are undertaken (

summary

). However, it becomes apparent that these efforts will not be sufficient to ensure a viable reference rate in long run.

November 2016

Administrator of TOIS fixing, ACI Suisse, announces discontinuation of TOIS fixing effective December 2017

October 2017

NWG recommends SARON as alternative to CHF LIBOR and establishes two sub-working groups to focus on a possible transition away from LIBOR in loan and deposit markets (

ToR

Sub-NWG L&D

) as well as in derivatives and capital markets (

ToR

Sub-NWG D&C

).

Clearing of SARON swaps

commences on LCH and

Eurex

.

December 2017

TOIS fixing is discontinued.

June 2018

NWG releases recommended specifications for SARON futures (

term sheet

).

October 2018

NWG recommends using

compounded SARON

wherever possible as a term rate alternative. NWG considers it unlikely that a robust term rate based on SARON derivatives will be feasible.

NWG releases

checklist

to help market participants become operationally ready for LIBOR transition and discusses proposal for

fallback

template

for retail loans.

SARON futures start trading on

Eurex

in October 2018.

NWG recommends market participants to consider and assess

options

for using a compounded SARON

. Each financial institution is advised to define an action plan with respect to its product strategy.

February 2019

8. International overview of reform initiatives14

Published since 3 April 2018

Expected for Q4 2019

Published since 2009

Secured overnight funds

SONIA (Sterling Overnight Interbank Average Rate)

ESTER (Euro-Short Term Rate)

Secured overnight funds

Federal Reserve Bank of New York

Bank of England

European Central Bank

SIX Swiss Exchange

SOFR (Secured Overnight Financing Rate)

Working Group on Sterling Risk-Free Reference Rates

Working Group on Euro Risk-Free Rates

National Working Group on CHF Reference Rates

Unsecured overnight funds

Unsecured overnight funds

Publication date

Underlying market

Administrator

Alternative reference rate

Working group

Alternative Reference Rates Committee

Reformed since 23 April 2018

Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks

SARON (Swiss Average Rate Overnight)

TONA (Tokyo Overnight Average Rate)

Unsecured overnight funds

Published since 1992

Bank of Japan

Sources:

NY Fed

,

BoE

,

ECB

,

SNB

,

BoJ

Development of term structure

Development of forward-looking term rate not before end-2021

Development of derivatives-based term rate as soon as practicable and only if

robust in order to facilitate transition in certain cash markets

Public consultation on methodology for a forward-looking term rate as a

fallback

for EURIBOR-linked contracts; recommendation expected

Derivatives-based term fixing not feasible;

recommendation to use compounded SARON wherever possible

To be discussed

9. Additional information and linksInternational working groupsSwitzerland: National Working Group on CHF Reference RatesUSA: Alternative Reference Rates Committee

UK:

Working Group on Sterling Risk-Free Reference Rates

Euro area: Working Group on Euro Risk-Free RatesJapan: Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks

National initiatives

FINMA guidance «LIBOR: risks of potential replacement»

Illustrative publication of SARON compounded rates by SIXProposal for draft fallback template for new retail loansInternational initiativesFinancial Stability Board’s Official Sector Steering GroupFSB Progress Report 2018

Andrew Bailey (CEO of the Financial Conduct Authority) held two important speeches in

July 2017

and

July 2018

ISDA work stream on derivatives

fallbacks for IBOR benchmark rates

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