Time for change? The future for NZ’s floating wholesale interest rate

Our thoughts

Likely outcomes

• It may be that no changes are made. As noted above, BKBM satisfies IOSCO Principles by accounting for actual trading of Bank Bills, and the principles acknowledge executable bids may be appropriate where actual trading is limited. BKBM also remains workable, and any ‘fix’ will create significant systems change work (and cost) and potential disruption for loans, fixed rate notes and other cash markets (including the derivatives market), the effects of which have been clearly visible in the prolonged shift to SOFR and SONIA.
• It is also worth noting that Australia’s 2018 calculation changes to its BKBM equivalents, BBSY and BBSW, have limited the immediate need for an Australian RFR, so the usual trans-Tasman pressures for change are currently absent. If it’s not broken, we don’t need to fix it. However:
  
  • o As the consultation paper notes, trading volumes of Bank Bills have steadily declined in recent years with an increased reliance on executable bids and offers to determine BKBM. As noted by IOSCO, the so-called “inverted pyramid problem”, which sees dependency on a benchmark that is derived from a fraction of the traded products that it is then used for “raises concerns about market integrity, conduct risks and financial stability risks”. An additional existential threat has also now arisen from the Reserve Bank’s Liquidity Policy review (which may reduce banks’ ability to hold Bank Bills for liquidity purposes, eliminating a significant portion of the market). Any reduction in traded volumes could lead to volatility and dislocated pricing in the longer term, leading our regulators to make the decision for us.
  • Our continued reliance on a term rate for derivatives (that also support loan products) creates a conceptual ‘mismatch’ in cross-currency derivatives. Whereas a USD/GBP swap may involve overnight risk free rates for both ‘legs’, a USD/NZD swap is more likely to pit a term rate against an overnight RFR.
  • Accepted international best practice for benchmark design and governance has changed in the wake of RFR reform. NZ may be well-served to follow this popular trend as alignment promotes consistency, comparability and cross-border harmonisation of benchmark rates.
  • While currently BKBM broadly reflects cost of NZD funding, moving to a rate that is not tied explicitly to the NZ bank bill market would be sensible future-proofing. The banking and finance sector is continuing to diversify, and treasury funding sources continue to evolve. Funding can increasingly be obtained from firms other than traditional banks – whether that is from neo-banks, private credit or other sources – and BKBM does not uniformly reflect a financier’s cost of providing funds.
• Given the above considerations, it seems likely that an RFR will be identified and a shift will begin over the medium to long term. The derivatives market will be an initial focus to build swap volumes and develop the inputs to a term rate for cash products (e.g., corporate loan market borrowing rates). BKBM could be expected to remain at least until such time, not least to avoid a costly two-step redocumentation exercise for term products.

Likely RFR

It is too early to predict what RFR the market may adopt, and we encourage all interested participants to put forward their views to NZFBF. Considering the two options favoured in the paper:

• Official cash rate (OCR): It is unusual (to put it lightly) for an RFR to be based directly on a central bank rate. The option was dismissed at an early stage for both USD and Sterling rates – primarily because central bank rates are not directly ‘traded’ or reflect the cost of lending and borrowing by a broad range of active market participants, and that their direct link to the baseline wholesale rate use could limit central bank flexibility to implement more nuanced monetary policy.

Ultimately OCR only reflects one factor in the market’s cost of funds. For instance, central bank rates (being the rate payable on a bank’s RBNZ account balance) often diverge from actual cost of funds in very low interest rate environments, and the fact that market rates change on a daily basis (whereas central bank rates may not change for months at a time) clearly demonstrates other influences at play. However:

• OCR is already used as the basis for NZD overnight indexed swaps (OIS) so there is a precedent and the New Zealand market has been successfully based on OCR since its inception in 1999. Similarly, OCR is also typically used as the overnight interest rate for NZD collateral in the derivatives market (and, as the paper notes, is the current International Swaps and Derivatives Association fallback for BKBM); and
• Adoption of OCR would effectively allow the Reserve Bank to more bluntly impose monetary policy on the market – a factor that is front of mind with recent OCR hikes, and continued low-level concern over the impacts that digital currencies could have on monetary policy tools. There are risks to the use of OCR, however. The paper notes the possibility of disruption if the Reserve Bank moved to a ‘corridor’ (rather than a floor) monetary control system like the Federal Reserve.

• A rate based on repo markets: RFRs from repo markets have been a popular choice in overseas markets (e.g., SOFR for USD), and as market-determined rates they naturally take into account a wide variety of economic factors impacting overnight cost of funds. However, it is clear from the reports of relevant overseas working groups that volume of trading and diversity of participants is key to selecting such a rate.

New Zealand dollar markets are a fraction of those for USD and Sterling and could have wide volume swings (even if the average daily turnover is significant and exceeds the BKBM market), uneven market participation leading to perceptions of conflict issues, and be susceptible to market changes (such as from the Reserve Bank’s liquidity policy review).

Ultimately, we can take only limited lessons from the choices made for foreign currencies. New Zealand’s unique circumstances must be weighed up. Can we develop and maintain an overnight funding market that is deep, broad and liquid enough to be the cornerstone of our cash and derivatives markets? Or would we be better served taking the natural benefits that the OCR has to offer?

Effects on loan documentation and floating rate notes

If a change from BKBM to an RFR is considered necessary, then a high priority will be to plan for a term RFR for the loan and bond market to transition to over time. While a daily RFR works well for most derivative products, loan and bond products require a forward-looking rate for borrowing or issuing an amount over a particular term. All major RFRs now have term rates widely adopted by the market following significant work developing their methodologies.

Any term RFR and implementation process will need to minimise the costs of transition, promote a transparent and consistent market calculation to ensure loan transferability, liquidity and pricing competition, provide bank customers with clear rate calculations for ease of cash management and confirming financial covenant compliance and, lastly, allow time to integrate the new rate changes with other amendment or new funding processes.

Actions

We expect market participants and benchmark users will focus on a stock take of offered products to:

• Consider where and how BKBM rates are used today, to help identify the features any replacement rate (or supported term rate) would need, whether product provisions remain fit for purpose (e.g., interbank funding market disruption, interest payment notifications and fall backs) and the processes to implement any such changes;
• Identify any material ‘tough legacy’ contracts from the past. That is, contracts with a long duration and no clear ability to amend (whether through contractual amendment language or industry protocol). International RFR experience, and the need to pass legislative fixes, clearly demonstrates the difficulties in implementing a new rate even where participants are given a long lead time. As the Financial Times reported in May 2023, billions of dollars of US dollar loans remain tethered to LIBOR despite the end of June 2023 cessation deadline; and
• Include flexible fallback and rate replacement language and disclosure going forward.

Reviews should include contracts that directly rely on BKBM, such as floating rate loans and bonds, and those that include rates derived from BKBM, such as instruments or products that reference NZD swap rates (which currently reflect the price of interest rate swaps for BKBM).

Next steps

Submissions close on 18 August 2023. NZFBF expects to issue a second consultation paper early next year to seek views on viable replacement options, methodologies, administration and term rate development. NZFMA's decision can be expected following its April 2024 review.