Interest rate benchmark reform: Overnight risk-free rates and term rates
The FSB has recognised that in some cases there may be a role for risk-free rate-derived term rates.
Interest rate benchmarks play a key role in global financial markets. To ensure financial stability, benchmarks which are used extensively must be especially robust. Consistent with this, the FSB, working through the Official Sector Steering Group (OSSG) it set up to coordinate international work to review and reform interest rate benchmarks, welcomes the progress that has been made by public authorities and private sector working groups in transitioning to overnight risk-free, or nearly risk-free, rates (RFRs) that are sufficiently robust for such extensive use.
Some of the working groups on RFRs have considered the development of forward-looking term rates derived from overnight RFRs (also described as “RFR-derived term rates”). However, in many markets, notably the largest part of the interest rate derivative markets, transition to the new overnight RFRs, rather than to these types of term rates, remains particularly important. This is for a number of interconnected reasons:
Derivative markets represent a particularly large and often highly leveraged proportion of exposures to interest rate benchmarks.
The overnight index swap (OIS) structure substantially reduces the incentive to manipulate individual IBOR settings by removing the stub payment risk.
Deep and liquid derivative markets based on the overnight RFRs are an essential prerequisite for creation of robust term benchmarks.
Due to their basis in inputs from other derivatives markets, widespread use of term RFRs in derivatives would create the potential for actual or perceived conflicts of interest for market participants.
The derivatives industry has recognised the importance of these issues, and, where IBORs are ending, has developed mechanisms to transition cleared derivatives to overnight RFRs via CCP rule changes, and uncleared derivatives to overnight RFRs via the International Swaps and Derivatives Association (ISDA) Protocol.
The FSB has recognised that in some cases there may be a role for RFR-derived term rates and sets out the circumstances where the limited use of RFR-based term rates would be compatible with financial stability.