Swaps transactions among Thai banks is paving the way for the country to establish a baht-based means of pricing derivatives and loans – but the industry has a huge technology challenge to move from pilots to full-scale transacting.
By the end of next year, the world’s financial industry must have solved for the demise of LIBOR and a host of related indexes used to price derivatives and loans.
LIBOR, the London Interbank Offer Rate, is used to reference prices in U.S. dollars for $350 trillion worth of transactions, but it and similar “IBOR”s for other major currencies are set by panels of banks that have been found to be corrupt.
Now the financial industry worldwide is moving in fits and starts to price instruments with new benchmarks, and it’s a massive technological and operational effort.
“This problem is everywhere,” said Tanatip Tangjadetanapon, head of capital market trading management at Kasikornbank. For Thai banks, LIBOR has been the critical tool to price deposits and loans for both retail and wholesale businesses, including the biggest infrastructure project financings. “The technology can’t handle a complete change.”
The biggest reason for this is the nature of the new benchmarks. IBORs rely on the judgment of bank consortia to set prices. The new “Alternative Reference Rates” being introduced rely on the data of actual transactions in overnight repurchase agreements.
This data is far more reliable, but it’s backward looking. Banks can still quote a 1-month contract price, but they will only know the rate at maturity, rather than at the beginning of the period.
Banks are now updating their systems and clearing internal model valuations for these new instruments. Once that’s achieved, they can price them, and offer quotes for a loan or swap referencing ARR-indexed rates, which are fixed in arrears with backward compounding.
The technology can’t handle a complete changeTanatip Tangjadetanapon, KBank
But they won’t be able to offer clients full certainty on the cash to be paid at the end of the 1-month period until a few days before settlement.
This is different from the classic LIBOR setup, where the LIBOR 1-month rate is crystallized at the beginning of the period so the client knows the rate dow to the cent, one month in advance and with absolute certainty.
Down to the core
“Our core banking system needs enhancement,” said Wanthicha Pothanun, head of funding and money market at CIMB Bank Thailand. “We are working with other departments within the bank to enhance both our treasury and core banking systems.” The transition will require more clarification in areas such as accounting and tax.
KBank and CIMB Bank Thailand pioneered the first inter-bank swap using a new, post-LIBOR reference rate on August 30, using a capital-markets platform provided by Murex, a longstanding vendor to KBank. At the beginning of October, Siam Commercial Bank conducted the first swap with a Thai corporation, Minor International.
In Asia several big markets have relied on LIBOR, simply overlaying a local currency exchange in order to represent LIBOR in their own markets. About $610 billion worth of contracts are based on the Thai Baht Interest Rate Fixing (THBFIX), an index managed by Bank of Thailand based on LIBOR.
This transition of legacy contracts impacts all of a bank’s processesAlexandre Bon, Murex
Singapore, India and the Philippines also rely on synthetic LIBOR benchmarks.
In April 2020, Bank of Thailand announced a new benchmark to replace THBFIX. Called THOR, for Thai Overnight Reference Rate, this is based on observable data from overnight repo (called the Overnight Index Swap, or OIS). The benchmark is genuinely Thai, instead of merely translating LIBOR into baht terms.
“This index will reflect onshore liquidity of Thai baht independent of the U.S. dollar,” said Tanatip. “But it’s not easy.”
These new indexes, with prices based off of OIS prices, will give local central banks more effective monetary powers. The U.S. Federal Reserve transmits interest rates via LIBOR. Asian central banks are using the IBOR crisis to create their own indexes – which means promoting indigenous repo markets.
These cash and derivative markets need to be built from the ground up, and attract their own liquidity, says Alexandre Bon, group co-head for LIBOR reform at Murex, and its point person for IBOR and interest-rate benchmark reform.
We all have a long way to goWanchitha Pothanun, CIMB Bank Thailand
“With these ARRs, the final interest payment can only be known with certainty at the end of a period,” Bon said. “This is a new issue for corporate treasurers who, in a LIBOR world, were used to knowing their cash flows 90 days in advance. This represents a real challenge for their processes but also for their loan and swap systems, which often cannot handle daily fixings and the new product conventions.”
This is a big change from what Thailand could have done, which is simply import the new U.S. dollar pricing index (called Secured Overnight Financing Rate, or SOFR; there are others now for yen, euro, Swiss franc and sterling).
The Monetary Authority of Singapore is also encouraging its banks to shift to a homegrown index, and India and the Philippines are expected to follow suit. This raises questions about how financial institutions – banks as well as their buy-side clients – can adapt their existing core systems to the new benchmarks, and how readily different systems will link and communicate.
The matter is especially urgent because not only will the U.K. stop regulating LIBOR after 2021, but there are many contracts outstanding that mature after that – at which point the reference benchmarks for their prices will have been retired.
“This transition of legacy contracts impacts all of a bank’s processes,” Bon said.
Thailand and other Asian countries therefore are eager to roll out local reference benchmarks to build liquidity among these legacy contracts, and thereby build momentum behind THOR and other new indexes.
Once they build out a yield curve for OIS, banks can offer interest-rate and cross-currency swaps, and build structured products.
Wanthicha at CIMB says the bank has built a yield curve for OIS. “We are ready for OIS operations,” she said. CIMB plans to start quoting cross-currency swap prices based on THOR OIS “as soon as our system is ready to meet client needs.”
“We all have a long way to go for enhancing core banking systems, legal documentation, finance treatment and risk-management models,” she added.
The embryonic nature of using onshore benchmarks to price contracts is in stark contrast to the dominance of the U.S. dollar in cross-border transactions.
“The dollar is still influential in the forex swaps market,” KBank’s Tanatip said. “We don’t know if it [OIS pricing off THOR] will work, but we do know we won’t have LIBOR anymore.”