09 Oct BCBS – At the crossroads in the transition away from LIBOR – from overnight to term rates
October 9, 2020 –
When LIBOR goes out of use at the end of 2021, financial contracts will need to use LIBOR alternative rates, which will be secured overnight financing rate (SOFR) in the US. A measure of the cost of borrowing cash overnight collateralized by Treasury securities. Unlike LIBOR – which is a term rate – SOFR and other alternative rates, are all overnight rates.
Basel stated that, ideally, financial contracts would use a term rate based on compounded overnight rates over an interest rate period, known as in arrears. Doing that, the interest rate payment is known at the end of the period. This is standard in the derivatives market, in the cash market, standard so far based on quarterly payments, with interest rate payment known at the start of interest rate period. Need to change the cash market standard impending shift from LIBOR to alternative rates.
The paper showed how to optimally determine a term rate known at beginning of the interest rate period by only using overnight rates, a method referred to as in advance. While resulting term rates are known at the beginning – as with LIBOR – a common objection is that this method introduces a lagged behavior, or basis. This can be especially severe in periods when policy rates change rapidly. In this working paper, Basel analyzed how the basis can be reduced. Stated only robust reference rates should be used, to avoid using reference rates based on unreliable data, therefore recreating the fallibility of LIBOR. Using past overnight rates to determine payment of the next interest period is robust.
Basel compared several approaches to reduce the basis by using term rates known at the beginning of the interest period, with one approach including an adjustment factor. This is viewed as the convenience premium to have the term rate pre-determined. Basel concluded that the ideal option is to use a shortened observation period when compounding overnight rates to derive a pre-determined term rate.
For more information, visit www.bis.org