A key milestone recommended by the Working Group on Sterling Risk-Free Reference Rates (‘the Working Group’) is to cease initiation of new GBP LIBOR-linked non-linear derivatives expiring after 2021 by end-Q2 2021, other than for risk management of existing positions.
To support market participants in meeting this milestone as soon as possible, the Working Group’s Path to ending new use of GBP LIBOR linked derivatives suggested exploring the potential to change standard trading conventions in non-linear derivatives to a SONIA basis during Q2 2021. The FCA has therefore engaged with participants in the non-linear derivatives market, including liquidity providers, buy-side firms and interdealer brokers (IDBs) to determine support for, and the feasibility of, this approach.
An FCA survey of these market participants identified strong support for a change in the interdealer quoting convention, which would see SONIA rather than LIBOR become the default price from 11 May 2021.
The FCA and the Bank of England support and encourage all participants in the sterling non-linear derivatives market to take the steps necessary to prepare for and implement these changes to market conventions on 11 May and shift liquidity away from GBP LIBOR to SONIA. In the period leading up to 11 May, the FCA and the Bank of England will engage with market participants to determine whether market conditions allow the switch to proceed smoothly.
Background & technical notes
This is an extension of the successful similar change to the interdealer quoting convention for linear sterling swaps during Q4 2020, which has supported a substantial move in trading volumes from GBP LIBOR to SONIA over subsequent months. Extending this to non-linear derivatives is intended to increase alignment in sterling markets and help to accelerate a reduction in new LIBOR exposures.
SONIA derivatives are likely to be the appropriate market convention for most contracts, particularly those maturing after 2021. The number of cases where market participants prefer LIBOR contracts is expected to reduce significantly as the end of 2021 approaches. Where new LIBOR transactions are entered into, market participants should be aware of the risks and take appropriate steps to establish that their clients are too.
The proposed change will involve IDBs moving the primary basis of their pricing screens and volatility surface construction for sterling non-linear derivatives from GBP LIBOR to SONIA. As a result, SONIA would be the primary pricing point for swaptions, caps and floors and other non-linear products.
These changes would not prohibit trading in GBP LIBOR non-linear derivatives but would mean the primary source of pricing and liquidity will switch from GBP LIBOR to SONIA. This, in turn, should encourage a greater proportion of GBP non-linear derivative trading volumes to switch to SONIA.
FCA survey results
Total respondents: 22
Q1. Do you support a ‘SONIA-First’ Convention Switch for the non-linear derivatives market? Yes / No.
100% of respondents selected ‘Yes’ to this question.
Q2. If you answered Q1 with Yes: Do you think a switch on 11 May 2021 would be an appropriate date for the interdealer non-linear derivatives market?
95% of respondents who selected ‘Yes’ to the first question supported the 11 May date.