Guy Debelle: Interest rate benchmark reform
Keynote speech by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the
ISDA (International Swaps and Derivatives Association) Forum (appearance via video link), Hong
Kong, 15 May 2018.
* * *
Good morning and thanks to ISDA for the opportunity to speak here today.
Reform of interest rate benchmarks has been a key focus of central banks and financial
1
regulators over recent years. These benchmarks are referenced in a wide range of financial
contracts, including derivatives, loans and securities. In light of the issues around LIBOR (the
London Inter-Bank Offered Rate) and other benchmarks that have arisen over the past decade,
substantial effort has gone in to reforming these benchmarks to support the smooth functioning
of the financial system.
Today I will provide an update on the work underway to strengthen interest rate benchmarks. I'll
focus on the developments since last year's announcement by the UK Financial Conduct
Authority (FCA) on the future of LIBOR. In particular, I will highlight the important role for 'risk-free'
interest rates as an alternative to credit-based benchmarks such as LIBOR. I will then
summarise the work underway to ensure that the major interest rate benchmark for the
Australian dollar, the bank bill swap rate (BBSW), remains robust for the long term. I will also
discuss how some credit-based benchmarks, such as BBSW, can coexist with risk-free rates in
a post-LIBOR world.
Global benchmark reform and the future of LIBOR
Central banks and financial regulators have been working with the industry to address the
shortcomings in the major interest rate benchmarks, the 'interbank offered rates' (IBORs). For
several years, the Financial Stability Board's (FSB's) Official Sector Steering Group (OSSG) has
been monitoring progress on three work streams:
1. to strengthen the IBORs by anchoring them to a greater number of transactions, and
improve benchmark governance
2. to identify robust alternative risk-free rates and encourage derivatives to be referenced to
them instead of the IBORs
3. to ensure that contracts referencing IBORs include robust fall-back provisions to reduce the
risk of financial instability if an IBOR were to be discontinued.
LIBOR is the key interest rate benchmark for several major currencies, including the US dollar
and British pound. In July last year, Andrew Bailey, who heads the FCA, raised some serious
questions about the sustainability of LIBOR. The key problem he identified is that there are not
enough transactions in the short-term interbank funding market to reliably calculate the
benchmark. The banks that make the submissions used to calculate LIBOR are uncomfortable
about continuing to do this, as they have to rely mainly on their 'expert judgment' in determining
where LIBOR should be rather than on actual transactions. To prevent LIBOR from abruptly
ceasing to exist, the FCA has received assurances from the current banks on the LIBOR panel
that they will continue to submit their estimates to sustain LIBOR until the end of 2021. But
beyond that point, there is no guarantee that LIBOR will continue to exist. The FCA will not
compel banks to provide submissions and the panel banks may not voluntarily continue to do so.
Let me be clear, LIBOR is not under threat because of the regulators. Rather it has been kept
going to date because of the actions of regulators, but that is not going to occur beyond 2021.
Then it comes down to whether the submitting banks are willing to maintain LIBOR in its current
form, and there is no guarantee at all that will be the case.
Andrew Bailey has made this announcement to give market participants enough time to transition
away from LIBOR. The process is not straightforward. LIBOR is referenced in around US$350
trillion worth of contracts globally. A large share of these contracts have short durations, often
three months or less, so these will roll off well ahead of 2021, but they should not continue to be
replaced with another short-dated contract referencing LIBOR. A very sizeable number of current
contracts would extend beyond 2021, with some lasting as long as 100 years. Market
participants that use LIBOR need to work on transitioning their contracts to alternative reference
rates. The transition will involve a substantial amount of work for users of LIBOR, both to amend
contracts and update systems.
Given how hard it has been to sustain LIBOR, regulators around the world have been working
closely with the industry to identify alternative risk-free rates that can be used instead of LIBOR.
These alternative rates are based on overnight funding markets since there are plenty of
transactions in these markets to calculate robust benchmarks. Last month, the Federal Reserve
Bank of New York began publishing the Secured Overnight Financing Rate (SOFR) as the
recommended alternative to US dollar LIBOR. For the British pound, SONIA has been identified
as the alternative risk-free rate, and the Bank of England has recently put in place reforms to
ensure that it remains a robust benchmark.
One issue is that the chosen risk-free rates are overnight rates, while the LIBOR benchmarks
are term rates. Some market participants would prefer for the LIBOR replacements to also be
term rates. While the development of term risk-free rates is on the long-term agenda for some
currencies, they are unlikely to be available anytime soon. This reflects that there are currently
not enough transactions in markets for term risk-free rates - such as overnight indexed swaps
(OIS) - to support robust benchmarks. Given this reality, it is very important that users of LIBOR
are planning their transition to the overnight risk-free benchmarks that are available, such as
SOFR for the US dollar and SONIA for the British pound.
For the risk-free rates to provide an alternative to LIBOR, the next challenge is to generate
sufficient liquidity in derivative products that reference the risk-free rates. This will take some
time, particularly for the US dollar, where SOFR only recently started being published.
Nevertheless, progress is being made, with the first futures contracts referencing SOFR recently
being launched.
Market participants also need to be prepared for a scenario where the LIBOR benchmarks
abruptly cease to be published. In such an event, users would have to rely on the fall-back
provisions in their contracts. However, for many products the existing fall-back provisions would
be cumbersome to apply and could generate significant market disruption. For instance, some
existing fall-backs involve calling reference banks and asking them to quote a rate. To address
this risk, the FSB has encouraged ISDA to work with market participants to develop a more
suitable fall-back methodology, using the risk-free rates that have been identified. But LIBOR is
very different from an overnight risk-free rate as it includes bank credit risk and is a term rate. So
the key challenge is to agree on a standard methodology for calculating credit and term spreads
that can be added to the risk-free rate to construct a fall-back for LIBOR. This needs to be
resolved as soon as possible, and we encourage users of LIBOR to engage with ISDA on this
important work.
Interest rate benchmarks for the Australian dollar
The key IBOR benchmark for the Australian dollar is BBSW. The RBA and the Australian
Securities and Investments Commission (ASIC) have been working closely with industry to
ensure that it remains robust.
The critical difference between BBSW and LIBOR is that there are enough transactions in the
local bank bill market each day to calculate a robust benchmark. Australia has an active bank
bill market, where the major banks issue bills as a regular source of funding, and a wide range of
wholesale investors purchase bills as a liquid cash management product.
For several years, BBSW has been calculated from the best executable bids and offers for the
bills issued by the major banks. This method is referred to as National Best Bid and Offer
(NBBO). Until recently, a significant concern had been the low trading volumes in the interbank
market at the time of day that BBSW was being measured (around 10.00 am). While there are
enough transactions over the course of the day, there were nowhere near enough occurring in
the (small) rate set window. We consulted with market participants on why there was a lack of
trading during the rate set, and they gave us a couple of reasons:
1. They faced a potential conflict of interest when they participated in the market underpinning
the benchmark and the derivatives market that references it. They stated that they were
uncertain about how regulators expected them to manage these conflicts.
2. Managers of investment funds were reluctant to trade at outright yields. They preferred to
transact at the yet-to-be-determined BBSW since this minimised tracking error against their
performance benchmarks.
To address these challenges, two key steps are being taken to support BBSW. First, the BBSW
methodology is being strengthened to enable the benchmark to be calculated directly from the
wider set of market transactions that occur each day. Second, a new regulatory framework for
financial benchmarks is being introduced.
The work on implementing the new BBSW methodology is progressing well. The new
methodology will involve calculating BBSW as the volume-weighted average price (VWAP) of
bank bill transactions.
The new methodology has broadened the BBSW rate set to include transactions outside the
interbank market during a longer trading window. This reflects that bank holdings of bills have
declined over recent years to around a tenth of total issuance. Holdings by investment funds
have increased to over half of total issuance. Previously, these investors had purchased bills
outside the rate set, agreeing to the transaction at the yet-to-be-determined BBSW rate. Since
late last year, banks and investors have been expected to trade bills at outright yields during the
rate set window. This change in market practice has been successfully implemented, enabling
these transactions to be used to calculate BBSW. The new arrangements are also improving the
infrastructure in the bank bill market, encouraging more electronic trading and straight-through
processing of transactions.
The Australian Securities Exchange (ASX) (the administrator of BBSW) has been conducting a
parallel run of the new VWAP methodology over recent weeks and the results are promising. On
average, there are around $1.5 billion in transactions during the rate set each day, with a wide
range of institutions participating. On most days, it has been possible to calculate the key
3month and 6-month rates using the VWAP method. In addition, the difference between the rate
calculated using VWAP and the existing NBBO method is very close to zero. Given these
results, there should be a seamless transition to the new BBSW methodology, which is due to
go live shortly.
The VWAP parallel run has confirmed that the most robust tenors are 3- and 6-month BBSW,
which are the tenors most frequently referenced in derivatives. Despite this, there are still many
contracts that reference 1-month BBSW. The liquidity of 1-month BBSW is lower than it once
was, mainly in response to the introduction of liquidity standards that have reduced the incentive
for banks to issue very short-term paper. Given this, users of products referencing 1-month
BBSW should consider referencing 3- or 6-month BBSW going forward.
The VWAP method will be at the top of a robust calculation waterfall for BBSW, so the
benchmark can continue to be published as conditions change in the bank bill market. If there are
not enough transactions on a day, BBSW will instead be calculated using NBBO (which is the
current method), and if quotes are unavailable, there are algorithms that can be used to calculate
the benchmark for a time.
To rebuild confidence in trading during the rate set window, the ASX worked closely with market
participants to develop a new set of trading guidelines for BBSW. These guidelines are an
important part of the new BBSW methodology, as they provide guidance on the trading of bank
bills during the rate set window. ASIC and the RBA have made it clear that they expect all bank
bill market participants - including the banks that issue the bank bills, as well as the participants
that buy them - to adhere to the guidelines and support the new BBSW methodology. This has
helped to address the concerns that some market participants had about trading during the rate
set.
Turning to the second key step to help ensure that BBSW remains a robust benchmark, the
Australian Government has recently introduced a new regulatory framework for financial
3
benchmarks. The legislation empowers ASIC to set the rules for and license administrators of
significant benchmarks such as BBSW. ASIC will also have the power to compel submissions to
a significant benchmark in the rare circumstances where the benchmark would otherwise cease
to be published. Finally, the legislation makes it an offence to manipulate financial benchmarks.
This new regulatory framework has helped to address the uncertainty that institutions were
facing when participating in the BBSW rate setting process. It should also support the continued
use of BBSW in the European Union (EU), where new regulations require benchmarks used in
the EU to be subject to a robust regulatory framework.
Finding the balance between credit-based and risk-free benchmarks
While we expect that BBSW will remain a robust benchmark, it is important for market
participants to ask whether BBSW is the most appropriate benchmark for their financial
contracts. This is particularly worth considering in the light of the transition that is taking place
away from LIBOR towards risk-free rates.
For some financial products, it can make sense to reference a risk-free rate instead of a
creditbased benchmark. For instance, floating rate notes (FRNs) issued by governments, non-financial
corporations and securitisation trusts, which are currently priced at a spread to BBSW, could
instead tie their coupon payments to the cash rate.
As the RBA's operational target for monetary policy and the reference rate for OIS and other
financial contracts, the cash rate is the risk-free interest rate benchmark for the Australian dollar.
The RBA measures the cash rate directly from transactions in the interbank overnight cash
market, and we have ensured that our methodology is in line with the IOSCO benchmark
4
principles. However, consistent with the challenges faced by users of LIBOR looking to
transition to alternative risk-free rates, the cash rate is not a perfect substitute for BBSW, as it is
an overnight rate rather than a term rate, and doesn't incorporate a significant bank credit risk
premium.
We think that BBSW can continue to exist even if credit-based benchmarks, such as LIBOR, are
discontinued in other jurisdictions. For many financial products, it will still make sense to
reference a credit-based benchmark that measures banks' short-term wholesale funding costs.
This is particularly the case for products issued by banks, such as FRNs and corporate loans.
The counterparties to these products would still need derivatives that reference BBSW so that
they can hedge their interest rate exposures. In the event that LIBOR was to be discontinued,
with contracts transitioning to risk-free rates, there may be some corresponding migration away
from BBSW towards the cash rate. This will depend on how international markets for products
such as derivatives and syndicated loans end up adapting in a post-LIBOR world.
The infrastructure is already in place for BBSW and the cash rate to coexist as the key interest
rate benchmarks for the Australian dollar. The OIS market is linked to the cash rate and has been
operating for almost 20 years. It already has good liquidity at the short end, and the infrastructure
is there for longer term OIS. A functioning derivatives market for trading the basis between the
benchmarks is important for BBSW and the cash rate to smoothly coexist. Such a basis swap
market is also in place, allowing market participants to exchange the cash flows under these
benchmarks.
Conclusion
There are three main points I would like to leave you with concerning interest rate benchmarks.
First, the longevity of LIBOR cannot be assumed. You should be considering today what that
might mean for any contracts you have that reference LIBOR. Please do not hope that if you wait
long enough, all the problems will go away. Users of LIBOR should pay close attention to the
work being undertaken by ISDA to establish more robust fall-back provisions on contracts.
Second, in Australia, in contrast to other markets, the changes to enhance the longevity of
BBSW are well advanced, and it has been possible to anchor the benchmark to a greater
number of transactions.
Third, users should consider whether risk-free benchmarks are more appropriate for financial
contracts than credit-based benchmarks.
There is still a place for robust credit-based benchmarks in the financial infrastructure, and we
expect that BBSW and the cash rate will be able to coexist as the key benchmarks for the
Australian dollar.
1
I have talked about this issue previously: Debelle G (2017). 'Interest Rate Benchmarks', Speech at FINSIA
Signature Event: The Regulators, Sydney, 8 September; Debelle G (2016), 'Interest Rate Benchmarks', Speech
at KangaNews Debt Capital Markets Summit 2016, Sydney 22 February; Debelle G (2015). 'Benchmarks',
Speech at Bloomberg Summit, Sydney, 18 November.
2
The instruments traded in the bank bill market are typically negotiable certificates of deposit (NCDs).
3
See <www.aph.gov.au/Parliamentary_Business/Bills_Legislation/Bills_Search_Results/Result?bId=r5962>.
4
For more details about the methodology for the cash rate, see <www.rba.gov.au/mkt-
operations/resources/cash-rate-methodology/>. The RBA has also conducted a self-assessment against the
IOSCO benchmark principles: <www.rba.gov.au/mkt-operations/resources/cash-rate-
methodology/compliance.html>.