Deep, liquid, and transparent (DLT) assessment of the Sterling Overnight Index Average (SONIA) Overnight Index Swap (OIS) market - June 2021

Background and purpose of this report

Since 11pm on Thursday 31 December 2020, the PRA has been required to publish Solvency II technical information (TI) for each relevant currency, including the basic risk-free rates (RFRs).^{footnote [1]} The RFRs must be based on financial instruments traded in a deep, liquid, and transparent (DLT) financial market.^{footnote [2]} A DLT assessment (DLTA) of each relevant market must be carried out to determine for which maturities of instrument that market is DLT; rates for those maturities are then used as inputs to the RFR curve. The longest maturity for which a market is judged to be DLT is termed the Last Liquid Point (LLP).

This report sets out the results and analysis for the PRA’s first DLT assessment of the SONIA OIS market. It has been produced to support the transition of the GBP RFR to reference SONIA OIS (instead of Libor swaps) from July 2021 onwards. ^{footnote [3]}

Conclusions

The key conclusions of this assessment are that:

(1) The last liquid point (LLP) for the SONIA OIS market is 50 years; and

(2) The SONIA OIS market is considered DLT at the following maturities: 1-10, 12, 15, 20, 25, 30, 40 and 50 years.

This report focuses on the rationale and analysis underlying the determination of the LLP. The PRA conducted similar quantitative and qualitative analysis to determine the intermediate DLT maturities.

Basis for the DLT assessment

In June 2021 the PRA published an updated Statement of Policy (SoP) ‘The PRA’s approach to the publication of Solvency II technical information’, which sets out how the PRA will carry out DLTAs for markets in PRA relevant currencies.^{footnote [4]} The SoP states that:

• The volume indicators used for assessing the liquidity of a swap market are:
  • average (over one year) daily notional turnover of at least £45 million; and
  • average (over one year) daily number of trades of at least ten.
    
• The PRA may also consider other metrics in order to supplement its assessment as required for the relevant currencies, which will be set out in its published results and analysis of the DLT assessment.

The SONIA OIS market is currently undergoing a transition. In March 2021, the Financial Conduct Authority (FCA) and ICE Benchmark Administration (the administrator of Libor) announced that publication for all GBP Libor tenors would cease after Friday 31 December 2021. Liquidity is therefore in the process of transferring away from GBP Libor swaps into other instruments, predominantly SONIA OIS.

In light of the continuing evolution of the SONIA OIS market, the PRA considers that the volume indicators mentioned above, being based on annual averages, are not the best guide to the likely DLT status of SONIA OIS at the point of the GBP RFR transition in July 2021, nor potentially for some time beyond. The PRA has therefore also considered other metrics: observed trends in the monthly averages of daily notional turnover and daily number of trades; observed trends in bid-ask spreads; and insights from market participants and from relevant Bank of England and FCA publications. These are set out in the Analysis section of this report.

Analysis

Volume indicators

The PRA has analysed the volume indicators using aggregated swap data from the EMIR Trade Repositories dataset, which encompasses the vast majority of all cleared and uncleared GBP vanilla interest rate swap trades.

Using data up to Friday 30 April 2021, the volume indicators (as described above) taken in isolation would suggest a LLP for the SONIA OIS market of 30 years. This is primarily because the average (over one year) daily number of trades is below 10 for the 40 and 50-year maturities. However, a backward-looking one-year averaging period does not reflect the current or expected future trading conditions in a rapidly-growing market. Therefore, the PRA has also considered the trends in the average (over one month) of the daily notional turnover and number of trades for SONIA OIS at different maturities.

Observed trends in the averages (over one month) of daily notional turnover and daily number of trades

Daily notional turnover: The monthly averages of daily notional turnover for the past three months have exceeded £45 million for each of the 30, 40, and 50 year OIS maturities. (Chart 1 below, indicates that the 30 year maturity has consistently met the notional threshold since February 2019. Chart 2 highlights the increase in notional turnover at the 40 and 50 year maturities since August 2020.) This suggests that, if market activity continues at or above the level seen in recent months (as is expected), the average (over one year) of daily notional turnover for each of the 30, 40, and 50 year maturities will also exceed £45 million in the future.

Daily number of trades: Chart 3 illustrates how the 30-year maturity has consistently met the ‘number of trades’ threshold since February 2020, while Chart 4 shows the gradual increase in trades at the 40 and 50 year maturities. Further increases in the liquidity of SONIA-based swaps, up to and including 50-year maturities, are expected during the remainder of 2021 following several initiatives to build liquidity in SONIA, as discussed in the final section of this report.

Bid-ask spread data

The PRA has considered the trends in bid-ask spreads for GBP Libor swaps and SONIA OIS. Chart 5 (below) displays how SONIA OIS bid-ask spreads have consistently narrowed since Q1 2020 across all maturities, indicative of increasingly DLT market conditions. In April 2021 the average bid-ask spread on SONIA OIS was narrower than that for GBP Libor swaps for several maturities (including the 50-year).

Libor transition initiatives and insight from market participants

Andrew Bailey’s speech (May 2021)^{footnote [5]} noted that the FCA and Bank of England supported and encouraged liquidity providers in the Sterling swaps market to adopt new quoting conventions for inter-dealer trading based on SONIA instead of Libor from 27 October 2020.^{footnote [6]} This ‘SONIA-first’ convention switch in the inter-dealer market has successfully catalysed the movement of most Sterling swaps business away from Libor.^{footnote [7]}

Since 11 May 2021, the FCA and Bank have similarly supported and encouraged liquidity providers in the Sterling non-linear derivatives market to adopt new quoting conventions for inter-dealer trading based on SONIA instead of Libor. The Working Group on Sterling Risk-Free Reference Rates recommends that, where viable, active conversion of all legacy GBP Libor contracts expiring after end-2021 is completed by end-Q3 2021.^{footnote [8]} Additionally, several central counterparties (CCPs) have announced that from Friday 17 December 2021 they will contractually convert outstanding Libor products and remove these benchmarks from their list of contracts eligible for clearing.

Owing to these developments, market contacts (such as asset managers, pension funds and market makers) expect further increases in the liquidity of SONIA-based swaps, including for longer-term swaps (up to and including 50-year maturities). Similarly, a recent Bank of England consultation paper includes the judgement that the volume and liquidity of GBP Libor cleared trades will fully switch to SONIA by Monday 20 December 2021.^{footnote [9]} It therefore proposes extending the mandatory clearing obligation to SONIA trades with a maturity in the range of 7 days to 50 years.