IBOR reform in Switzerland:
Transition from CHF LIBOR to SARON (part I)
The Financial Conduct Authority (FCA) will stop supporting LIBOR from the end of 2021, while more than 80% of CHF loans are currently priced based on the CHF LIBOR. According to the Swiss National Working Group, the Swiss Average Rate Overnight (SARON) is the proposed replacement standard. The transition period poses a number of different challenges for the market.
The London Interbank Offered Rate (LIBOR) is the most widely used interest rate benchmark and serves as a price reference for a broad range of financial instruments. Figure 1 shows the Swiss market where around 80% of the CHF loans derive their price from the CHF LIBOR.
Figure 1: Basis for pricing of CHF loans (SNB Bank Lending Survey, 2019).
One of the key drivers for the reform and transition away from LIBOR is the decline in liquidity of the underlying interbank markets. In fact, during the speech of July 2018 at Bloomberg London, the Chief Executive of FCA rephrased the definition of LIBOR as “measuring the rate at which banks are not borrowing from one another”. Due to a lack of liquidity in the underlying interbank markets, the calculation of LIBOR is predominantly based on expert judgment provided by the submitting panel banks. Figure 2 shows the consequence of a lack of liquidity on the calculation of the LIBOR with respect to three levels:
Level 1: Transaction-based - LIBOR submission is equal to the volume weighted average price of eligible transactions (e.g. unsecured deposits).
Level 2: Transaction-derived - Contributor Bank has insufficient eligible transactions to make a level 1 submission. LIBOR submission is then based on transaction-derived data.
Level 3: Expert judgment - Contributor Bank has insufficient eligible transactions or transaction-derived data to make a level 1 or level 2 submission.
Figure 2 shows how LIBOR (for currencies USD, EUR and CHF) is derived in terms of the three levels. It can be concluded that the calculation of CHF LIBOR is almost entirely based on expert judgment instead of actual transactions. For USD and EUR, level 1 (transaction-based) contributed most to submissions of LIBOR in short-term tenors (overnight and 1-week).
Figure 2: Proportion of panel bank submission used to calculate LIBOR that are transaction-based, transaction-derived or based on expert judgment (ICE, 2019).
Finally, FCA ensures that 20 panel banks will continue making submissions until end-2021. After this date, it is possible that the withdrawal of banks from the LIBOR panels may make the production of the LIBOR rate unfeasible. Moreover, even if some panel banks will continue supporting LIBOR, it could be impossible to produce a representative LIBOR rate of the relevant underlying market (i.e. not meeting the EU Benchmark Regulation on the use of reference rates in new in-scope financial products).
What is SARON?
Swiss Average Rate Overnight (SARON) is a rate which reflects the conditions of the overnight transactions in the secured CHF money market and it is administrated by SIX Swiss Exchange. Importantly, the overnight segment of CHF repo market is the most liquid segment of the CHF money market.
SARON is calculated as a volume-weight average of transactions and binding quotes (i.e. quotes that are legally contracted and hard to adjust once put into effect) in the order book of SIX's electronic trading platform. It is continually calculated in real-time and published every 10 minutes. However, a fixing is conducted three times a day at 12 p.m., 4 p.m. and 6 p.m. The latter, which is produced immediately after the market closes, serves as a reference rate for derivative financial products and the valuation of financial assets.
On the other hand, the USD Secured Overnight Financing Rate (SOFR) daily reset is published at 08:00 a.m. NY time on T+1, the day after the underlying Overnight repos were traded. Nevertheless, the Federal Reserve has the ability to correct and republish the rate until 02:30 p.m. NY time on T+1. Users may wish to reference the rate after this time (e.g. 03:00 p.m.). Moreover, the Euro Short-Term Rate (€STR) is published at 08:00 a.m. Frankfurt time on T+1, reflecting the overnight unsecured fixed-rate deposits trading activity over EUR 1M on day T.
Finally, SARON has a clear governance in place and complies with international benchmark standards. The same will apply for SOFR and €STR.
Compounded SARON as term rate alternative to CHF LIBOR
There is an essential difference between contracts linked to CHF LIBOR and compounded SARON. When using a term reference rate (e.g. 3M LIBOR) as a benchmark in a financial contract, the interest payments are known at the beginning of the interest period. This type of forward-looking term rate (i.e. in advance payment structure) reflects the expected level of interest for the next three months, equivalent to a sequence of expected overnight rates.
On the other hand, using compounded SARON, interest payments are the result of a daily compounded interest rate (interest-on-interest). These rates are defined as backward-looking term rates (i.e. in arrears payment structure) and they reflect the realized level of interest over the past three months, equivalent to a sequence of realized overnight rates. Figure 3 (below) represents the described situation with the LIBOR forward-looking term on the left and the SARON backward-looking term on the right.
Figure 3: Difference between forward-looking term (LIBOR on the left) and compounded term rate (SARON on the right).
The example shown in figure 4 helps to explain how the calculation of the 1-month compounded SARON rate is made in three steps: 1. For every daily SARON fixing (at 6:00 pm), a rate factor is calculated; 2. For compounding, the product (multiplication) over all the rate factors is calculated; 3. The rate is adjusted on an ACT/360-days basis.
Figure 4: Calculation of the 1-month compounded SARON rate in three steps.
In this example, the 1-month compounded SARON is calculated to be -0.7451%. SARON can be applied in either a backward- and forward-looking manner, in the following ways: - Backward-looking at the end of the fixing period (compounded SARON backward-looking). Before the start date of the contract, the exact payment on payment date is unknown. - Backward-looking at the beginning of the fixing period (compounded SARON forward-looking). At the start date, the exact payment on payment date is known.
To better understand the difference between a backward- and forward-looking rate with SARON as a reference rate, an example is provided in figure 5 and figure 6.
Figure 5 shows how SARON can be compounded backward-looking considering that it happens at the end of the fixing period (in arrears). At the end date, the 1-month compounded SARON is backward-looking calculated as is figure 4 between the start date and the end date. At the start date, the exact payment delivered on the Payment Date is unknown.
Figure 6 shows how SARON can be compounded as a “SARON forward-looking” rate, using a backward-looking approach but at the beginning of the next fixing period (in advance). The 1-month compounded SARON is still calculated backward-looking, but between 05.08.2018 and 05.09.2018. Finally, the 1-month compounded SARON rate is applied over the next period. In this case, the exact payment is known in advance (at the beginning of the Start Date).
Figure 5: Ex-post / Backward-looking at the end of the Fixing Period / Compounded SARON backward-looking.
Figure 6: Ex-post / Backward-looking at the beginning of the Fixing Period / Compounded SARON forward-looking.
Swiss National Working Group (NWG) recommendations
The forward-looking term rate could potentially also be derived from the SARON derivatives. However, the Swiss NWG assessed the feasibility of a forward-looking term rate based on SARON derivatives (e.g. SARON swaps and futures) and argued that a robust fixing is unlikely to be feasible. For this reason, NWG recommends using a compounded ARON applied forward-looking (as shown in figure 6), wherever possible. NWG has also published specific options on how a compounded SARON could be used as a benchmark in financial contracts. The reasoning behind these options is based on the mitigation of uncertainty regarding future cash flows.
Moreover, for existing contracts with maturity beyond 2021, fallback provisions to support the contract continuity are needed. Appropriate fallbacks should enable the conversion of contracts when LIBOR ceases to exist and help to reduce the risk of disagreement or dispute on rights and obligations derived from LIBOR-referencing contracts.
These three topics will be explained in more details in the next article on this subject, which will be published in our next edition.