Reference RatesMedium

A number published once a day decides the coupon on a loan, the payment on a swap and the interest on a mortgage. How that number is produced is a design decision, and it was redesigned after the old design failed.

8 min read · 1 353 words

What a reference rate is for

Two parties agree a floating payment. They could each observe borrowing costs themselves and argue about the number every quarter, or they could name a published figure and agree to use whatever it says. Naming a figure is cheaper, and it is what almost every floating contract does.

That makes a reference rate a piece of shared infrastructure rather than a market in its own right. It is referenced by loans, by interest rate swaps, by floating rate notes, by mortgages, by the discounting inside a valuation, and by the interest paid on posted collateral. Change the number and payments change everywhere it is written down at once — which is why the design of the number is a matter of some seriousness, and why replacing one is a multi-year exercise rather than an announcement.

The old design, and why it was replaced

The dominant benchmarks were built on submissions: a panel of banks answered a question each morning about the rate at which they could borrow unsecured for a given term, the extremes were trimmed, and the remainder was averaged.

Two structural problems, independent of anybody's conduct:

• The answer was a judgement, not a transaction. Unsecured interbank lending at three, six and twelve months became rare, so panel banks were being asked to estimate a rate at which they were not actually borrowing. An input that is an opinion is an input somebody can be lobbied about, and market abuse covers why benchmark inputs are treated as they now are.
• The rate carried bank credit inside it. An unsecured interbank borrowing rate embeds the market's view of bank credit, so the benchmark widened when banks became less creditworthy — a feature in one context and a serious problem in another, since it moved the coupon on every referencing contract for reasons that had nothing to do with the borrower.

The replacement principle is the same in every jurisdiction that made the change: anchor the number in actual transactions, in a market with enough volume to be robust every single day.

The new design: overnight, near risk-free, compounded in arrears

The successor rates are overnight rates computed from real trades — some secured by government collateral, some unsecured wholesale deposits, depending on which market in that currency is deep enough. Three consequences follow, and each one changed how a contract has to be written:

• They are overnight, and contracts pay quarterly. So the rate for a period is built by compounding the daily fixings across it, rather than being read off a single publication.
• They are known in arrears. Compounding across the period means the payment amount is only final at the end of it, where the old term rate was known at the start. Borrowers who need to know a payment in advance get a lookback or an observation shift written into the contract — small mechanical devices that buy a few days of notice at the cost of a slight mismatch.
• They contain no bank credit. Which is the point, and also the reason a lender whose own funding cost rises in a stress finds the benchmark no longer moving with it. That gap is real, it is an economic exposure for the lender, and it is why credit-sensitive add-ons continue to exist alongside the risk-free rates in some markets.

Curve construction covers what these rates then feed: the discounting curve, the forwards, and the arithmetic that turns a series of overnight rates into a price for something ten years long.

Term rates: the thing everybody wanted back

A borrower drawing a loan wants to know the interest before the period rather than after it. So forward-looking term rates were constructed on top of the overnight benchmarks — derived from the derivatives market's own expectations of where the overnight rate will average.

They exist, they are used, and their use is deliberately limited: a rate derived from a derivatives market is only robust while that market is liquid, and building the whole floating-rate universe on top of it would recreate the fragility the reform was designed to remove. The general position is that term rates serve cash products where the timing genuinely matters, while derivatives reference the underlying overnight rate directly.

The fallback problem, and why it was so much work

Millions of existing contracts named a benchmark that was going to stop. A contract that says "the rate is X" and X ceases to exist is a contract with a hole in it, and litigation over what should fill the hole was the outcome nobody wanted.

• A trigger — a defined event, usually a formal announcement that the rate has ceased or is no longer representative, rather than a judgement anybody makes for themselves.
• A replacement — the named successor rate.
• A spread adjustment — because the successor is structurally lower, being nearly free of bank credit. The adjustment is a fixed figure computed from the historical median difference over a long window, and it is fixed on purpose: a floating adjustment would reintroduce exactly the credit sensitivity being removed, and a negotiated one would be a renegotiation of millions of contracts.
• Legislation, where consent was impossible. For contracts that could not realistically be amended — bonds with dispersed holders, mortgages with individual borrowers — several jurisdictions substituted a replacement by statute.

Two things are worth noticing here. The whole exercise is a transfer of value in miniature: any imperfection in the spread adjustment moves money between payer and receiver on every affected contract. And it is a case study in a general lesson — a reference embedded in millions of documents is infrastructure, and infrastructure cannot be changed quickly however wrong it is.

Where else a published number does this job

• Inflation indices for index-linked bonds — the reference decides the coupon and the redemption, and the index is a statistical construction with its own revision policy. Inflation covers why the index and any particular household's experience differ.
• Foreign exchange fixings, used for a valuation or an index rebalance at a defined moment. A window rather than an instant, for a reason connected to the closing-price patterns in market abuse.
• Equity index levels, which decide what a tracker holds and what a derivative pays — what an index really is takes it apart.
• Credit-event determinations, where a committee decides whether a defined event has occurred and therefore whether protection pays.

The common shape: a published figure that many contracts point at, produced by a rule, governed by an administrator, and consequential out of all proportion to its own market.

What to take away

• A reference rate is shared infrastructure: change it and every referencing contract changes at once.
• The old benchmarks rested on judgement about a market that had thinned, and carried bank credit inside them.
• The successors are overnight, transaction-based, and compounded in arrears — so the payment is final at the end of the period rather than the start.
• Term rates exist for cash products where timing matters, and are deliberately not the universal answer.
• Fallbacks need a trigger, a successor and a fixed spread adjustment, and the adjustment is fixed precisely to avoid reintroducing credit sensitivity.