Regulatory finance update: £ RFR Non-linear market - are we nearly there?

As we enter the 'endgame' for LIBOR1 (as the official sector is fond of calling it - too much Marvel during lockdown?), a key part of the derivatives market that seems 'stickier' is Non-Linear.

So where are we and what’s the path forward?

The focus has up until recently been on creating a liquid linear SONIA3 market. One could argue this has been a success via certain announcements and initiatives. Last October we saw the working group make a big push for ‘SONIA first’ which saw surge in liquidity with the broker market moving to defaulting to SONIA rather than LIBOR.

The non-linear space began its preparations to move to SONIA Swaptions & Cap Floors in the summer of 2017 when the FCA4 announce plans to end LIBOR. Prices in SONIA Swaptions had very sporadically been shown in previous years despite at NatWest being open for business. The first Swaption traded in the market in November 2019 but they have traded only on a couple of occasions since.  That said we are now seeing increasing inquiries for SONIA Swaptions which will help the market move forward.  SONIA Cap Floors have traded more regularly but still not that frequently.

What’s changing?

As we wrote last year, the RFR task force focus is for the market to transition to no new Non Linear £LIBOR trades with maturity beyond 2021 (except for risk management purposes) by the end of Q2 this year. ICE5 began producing SONIA Swap fixings in go live format this January having had a “Beta” test phase at the end of last year. With X about to be set, Linear LIBOR brakes about to be put on and the possibility of a ‘SONIA first’ for non-linear, are we about to see this market really blossom?

Differences with LIBOR market

Swaptions will not trade Cash IRR6 as standard. The market was due to transition away from LIBOR Cash IRR to LIBOR Collateralised Cash Price this year, however with upcoming LIBOR reform this transition was deemed worthless and cancelled.

Until recently SONIA Swaptions have traded Physically settled vs LCH. One would expect they will continue to trade Physically settled on some occasions but with the SONIA Ice fixing live the market has now switched to Cash Settled versus Collateralised Cash Price as the standard.

SONIA Cap Floors are different in their optionality profile to LIBOR Cap Floors. SONIA Caps & Floors fix at the end of the of the Coupon Period versus the daily compounded average. The optionality of SONIA Caplets / Floorlets lasts longer than the equivalent LIBOR Caplet / Floorlet where the optionality ceases at the start of the coupon period.

Where are we now?


Liquidity in SONIA Swaption has improved in terms of the width and frequency of prices shown in the broker market, but volumes of actual trades remain low relative to LIBOR trades. SONIA Cap Floors are seeing relatively more trading activity, with volumes moving closer into line with that of LIBOR equivalents.

Once the fall back spreads are formally announced, the market becomes fungible and we would expect bid/offer to move closely in line with LIBOR for contracts expiring comfortably post cessation. Given the target outlined by the Bank of England to not trade any new LIBOR based non-linear products (with exceptions) by end Q2, it would be sensible for the market to find a SONIA first date sometime in the second quarter. Such an approach would then mirror that of the linear market last year.

From an operational standpoint, both Marketwire & Markit (Totem) IPV7 service are going live this weekend, which will provide its first returns versus SONIA this month. For any investors waiting for such developments, this may provide a step closer to being ready to migrate to SONIA Swaptions.

To give an idea on CURRENT liquidity, here a few structures with indicative Bid/Offer spreads in basis points for standard market sized transactions:

What are different client bases doing?

Real Money: We have started to see the first signs of Real Money clients moving towards trading SONIA Swaptions in 2021. Given the trading we have seen, and the bid/offer spreads shown, these participants appear to be getting good liquidity overall. From our conversations with clients yet to move, there is plenty of appetite for the move to SONIA as soon as feasibly possible. Q2/Q3 cited as expected timeline in accordance with market guidelines and has been noted that investors looking to trade expiries going over the 2021 year end will aim to do in SONIA format (or LIBOR initially with a view to rolling into SONIA later in the year).

Hedge Funds: A few inquiries, but Hedge Funds focused on liquidity as paramount. There is a definite willingness to move, but they will likely let the market lead and follow when liquidity is like for like (confirmation of fall back spread should be a big kicker here).

LDI8Over the past few years we have seen a distinct shift away from using options from LDI. With the end of LIBOR on the horizon and typical expiries of LDI tending to be longer dated we saw a lot of these positions being transitioned into Sonia swaps. So far in 2021 we have seen a large increase in conversations, with accounts becoming quickly aware that relying on fallbacks might not be applicable to the volatility strategies they run. We have seen interest to transition existing collar positions as well as to look to enter into new trades now that pricing costs between LIBOR and SONIA Options have quickly converged. 

Corporates and Banks & Building Societies: Active in SONIA Caps Floors towards the end of last year and the start of this year. Suspect this will be an ongoing theme throughout this year.

And how do we deal with legacy?

Lots of focus on the ISDA9 protocol and fallbacks. As we wrote about before, this path may not work for the wider non-linear market.

Swaptions: The Non Linear RFR Working group has been working on a formula that will create an alternative LIBOR Swap fixing using the SONIA Swap fixings and the yet to be published fallback credit spread. We are optimistic that this will be published in the coming weeks. The formula can be used to settled Legacy Cash Settled Swaptions & CMS10 contracts but the replacement of the LIBOR Swap Fixing with the alternative LIBOR Swap Fixing will not be automatic. Some form of market wide amendment is required to shift existing LIBOR Swap Fixing contracts to the alternative method. ISDA & the Non Linear task force are working on this.

Legacy Caps Floors: The fallback will represent a significant change in valuations with the optionality changing as detailed above as the contracts move from fixing in advance at the start of the coupon period, to fixing in at the end of the coupon period versus compounded daily SONIA. There will also be a two day fixing lag applied to legacy contracts. The market is well aware of these changes & has repriced accordingly  

Other more exotic products can significantly change through fallback. These have been rarely traded so we won't go into them at length but details are given on the BOE document for non-linear transition and on the ISDA fallback statement.  

Anything else?

LCH conversion process for LIBOR trades to SONIA was recently consulted on. We are concerned regarding Swaptions that expire between the planned date for this LCH conversion process & actual LIBOR cessation. Physically settled LIBOR Swaptions would be unable to settle into the LCH. The fallback states these would be Cash settled. Cash settlement of these and standard Cash settled swaptions will likely be impossible as with the LCH no longer accepting LIBOR swaps the LIBOR ICE fixing will fail.

Watch this space

We expect the LIBOR cessation announcement fixing the spread adjustment any day now.  Question is what will this mean for the non-linear market?  Are we ready to see this market really take off?  Happy to have that conversation since we’re ready to go.

Phil Lloyd, NWM Sales

Christopher Michael, NWM Sales

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[1] LIBOR - London Inter-Bank Offered Rate

[2] RFR - Risk-Free Rate

[3] SONIA - Sterling Overnight Index Average

[4] FCA - Financial Conduct Authority

[5] ICE - Intercontinental Exchange

[6] IRR - Internal Rate of Return

[7] IPV - Independent Price Verification

[8] LDI - Liability Driven Investment

[9] ISDA - International Swaps and Derivatives Association

[10] CMS - Constant Maturity Swaps

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