Frequently Asked Questions

Yes.. you only need a moment to work out that the decision by the Federal Reserve (FED) to change the benchmark on the Main Street Lending Program (MSLP), in the aftermath of the Covid-19 lockdown, from SOFR to USD LIBOR, was taken because end users could not handle realised rates. And in their paper “Should SOFR get all the credit?” (published on 19 August 2020), JP Morgan identified that a lack of clarity around a forward looking term rate was the second most important factor (of six) for credit investors as to why they were struggling to adopt SOFR.

And if you look at settlements for SOFR OIS swaps, you will notice that even global banks need two days to make interest payments, after the end of the deal (on what is known as a T+2 payment basis). If we are to respect the overnight accruals of the main trading markets then we would have cash products, that reference SOFR, paying interest at least 2 days after the principal on a loan was returned. This is clearly not desirable, and thus, we would need to ”fudge” the accrual in such a way that end user related ARR deals (that reference a realised ARR rate) were no longer fungible with regular ARR contracts. This would create fragmentation in ARR liquidity (reducing available liquidity) and increase costs which would likely end up being paid for by end users. So even if end users do manage to overhaul their systems to handle realised rates, term rates set in advance will still offer a better solution to their financial market requirements.

Who can use FAIRFix?

Everyone.. The beauty of FAIRFix is that it allows all financial market participants to benefit from the use of a term fixing rate for ARRs.

Why is FAIRFix suitable for use by all, but other fixing methodologies are not?

The FAIRFix methodology allows end users to be benchmarked against an ex-post term ARR fixing rate (i.e. forward looking rate) while professional market participants end up benchmarked against an ex-ante realised overnight ARR rate (i.e. backward looking rate).

To see how this works refer to the link on Removing Conflicts.

Why can end users use a term rate while it is desirable for the professional market to be benchmarked against the realised rate?

End users need a term rate for three main reasons. Firstly their systems struggle to handle overnight in arrears accruals (cf. the decision by the FED to change the benchmark on the MSLP from SOFR to USD LIBOR). Secondly they require sufficient notice of the rate for cash management purposes (and in some cases legal purposes). And finally, normal cash market deals require the exchange of interest and principal on the end date of a deal.. This is not possible with overnight accruals (cf. SOFR OIS pay 2 days after the end date of the deal) on ARR unless you ”fudge” the accrual (and thus increase hedging costs) by referencing an incorrect accrual date, either for the entire term of the deal (with a ‘lookback’ or ‘observation shift’ to an earlier overnight fixing) or for the last few days of the deal (with a ‘lockout’ period where you reuse a single fixing for the last few days of a coupon period). FAIRFix solves all these issues and gives users a robust term rate so they can transition away from IBOR rates seamlessly.

The professional market participants need a realised rate as they trade overnight index swaps (OIS) on ARR that pay interest on an overnight compounded in arrears accrual basis. FAIRFix transforms their ARR fixing risk into overnight fixing risk that matches the fixing risk of the OIS swaps that they trade in the normal course of their business. Furthermore, and more importantly, if they were to end up with term fixing exposures, they would have a conflict of interest when participating in the markets that were responsible for determining the fixings.

What do end users need to do to start using FAIRFix?

Once FAIRFix is published, there will be nothing new that end users will need to do in order to start using FAIRFix in financial transactions. There are no system nor risk management upgrades needed to cut and paste the FAIRFix term fixing rate into current IBOR referencing products. And any requirements on parties to submit derivative derived orders, or reduce net exposures to nil, all lie with sellside financial institutions.

Who can submit non-competitive orders?

Anyone can submit non-competitive orders if they are not involved in the competitive part of the FAIRFix auction. They will simply need to be eligible to clear regular OIS deals to the chosen Central Clearing Counterparty (CCP) for that auction. If necessary, their clearing bank could perform this service on their behalf.

Additionally market makers are required to submit all daily fixing exposures to the FAIRFix auction as non-competitive orders in order to remove their pre-auction exposure to the fixing rate. This removes conflicts of interest from market makers ensuring that the fixing is determined by genuine supply and demand conditions.

What happens to non-competitive orders when they are submitted ?

All non-competitive orders are netted off pre-auction and the balance then enters the FAIRFix auction. This net balance then transacts with competitive orders at the best possible rate according to a Modified Dutch Auction protocol which matches all deals at a single rate. For example, if there were $5 billion notional of non-competitive orders to receive 3 month SOFR and $7 billion notional to pay, there would be a net balance of $2 billion notional to pay 3 month SOFR. If the order book of competitive offers at the auction had only $1 billion notional at 0.20% and $3 billion at 0.201% then the FAIRFix rate for that day (and the rate at which all orders would be executed) would be 0.201%. This is exactly the same methodology used for US Treasury auctions because ensures that market makers are incentivised to show their best possible prices for varying volumes of transactions (and in the case of FAIRFix, it means that there is a single auction transacted rate that is equal to the FAIRFix fixing rate, thus ensuring that FAIRFix fixings and the overnight realised rate are equivalent).

For more information on this process please refer to the link on Calculating FAIRFix.

Who can submit competitive orders?

Only market makers will be able to submit competitive orders. Banks and non-banks alike will be permitted to apply to become market makers, though they must be able to clear to the Central Clearing Counterparty (CCP) chosen for that particular FAIRFix auction. Only those parties that agree to the terms and conditions of market making will be permitted to submit competitive orders. These conditions will include a commitment (on a best efforts basis) to reduce all pre-auction fixing exposures to nil, to provide sufficient liquidity (dependent on the particular ARR market) at every auction and to provide sufficient notice if they decide to cease market making at that particular auction.

How will FAIRFix be determined if there are no transactions (e.g. at the start of the FAIRFix regime)?

The fixing will be determined by a weighted mid-market of competitive bids and offers.

If there are no transactions (e.g. at the start of the FAIRFix regime), will this mean the fixing is not representative?

No… at the start of the regime, there will be very few deals indexed against the benchmark and so there will be no reason to expect that the mid-market rate of competitive prices would not be representative (as market makers would not have any reason to move the rate up or down and thus would be expected to accurately represent the true mid market in their pricing as they will be showing live actionable bids and offers). In any case the plan is to publish the rate for several months before going live so that users can develop confidence that the rate is representative.

How does the Modified Dutch Auction methodology work?

The Modified Dutch Auction methodology settles at a level where there is sufficient liquidity to fully satisfy the non-competitive orders. Therefore if there is a net balance of non-competitive offers at the auction, the rate will start at the level of the best competitive bid and move lower until there is a sufficient notional volume of competitive bids to fully satisfy the balance of non-competitive offers. All bids above this level will be filled at this lower rate, while bids at the clearing level will receive pro-rated fills.

For more information on this process please refer to the link on Calculating FAIRFix.

Why was a Modified Dutch Auction methodology chosen for FAIRFix?

This ensures that market makers show their best possible prices as they know that if the total demand exceeds the supply at these prices, they will benefit from an improvement in the price to the level where supply and demand match and all transactions take place at that price. This means that the level the auction settles at is the equilibrium level for the given supply and demand conditions that prevail in the market for ARR OIS swaps. Finally, the single transacted rate allows end users the ability to switch their fixing exposures between the FAIRFix term rate and the realised overnight rate making both economically equivalent.

Can desks that run banking books submit non-competitive orders if their bank also has a market making desk ?

Yes… provided there is sufficient separation between the desks, there will be no conflict of interest and they can submit non-competitive orders freely.

Will it be possible for non-market makers who speculate in ARR markets to do a FAIRFix swap then manipulate the fixings in their favour?

No, this would not be possible. To see why, it is necessary to understand that every FAIRFix derivative deal by an end user, results in a non-competitive order in the opposite direction in a regular OIS swap (on the fixing date of the FAIRFix deal) to replace the risk that has just rolled off. For example, if a speculative account were to pay fixed in 20 billion notional for a 3 month FAIRFix swap in the hope of manipulating the fixing higher, this order would generate a non-competitive order (from the sell-side institutions that dealt with the speculative account), at the relevant FAIRFix auction, to receive fixed in 20 billion notional on a 3 month OIS swap (to replace the FAIRFix fixed rate risk that was rolling off). And as this flow would tend to lower, not raise, the FAIRFix fixing rate (according to supply and demand). So while the prevailing rate in the ARR market might move higher in the aftermath of the 20 billion notional flow as market makers looked to cover their exposures, this would be no more than would happen if the transaction had occurred in a regular OIS swap (which is entirely reasonable and in accordance with supply and demand conditions). However, when the deal matured there would be an equal and opposite effect that would tend to move the ARR rate down a similar amount as it had moved up in the first place.

Even if the would-be manipulator choose to put in a non competitive order to pay the FAIRFix rate at the auction (to negate the opposite order from the sell-side institutions), this would neutralise their exposure to the FAIRFix fixing (they would be receiving FAIRFix on their original deal and paying FAIRFix on this order) and it would simply result in them having a regular OIS position. And so there would be no way for a would-be manipulator to benefit from such an endeavour.

For more information please refer to the link on Preventing Manipulation.

Can Floating Rate Notes (FRNs) reference FAIRFix?

Yes.. For FRN issuers this simplifies the transition away from IBOR FRNs to ARR FRNs as they do not need to worry about which accrual methodology to use and whether their investor base can handle those accruals. They also afford themselves a greater notice period to cash manage the interest payments than they would have if they were to use an overnight in arrears accrual.

What if the FRN issuer wanted an overnight in arrears accrual?

Not a problem.. they could pay out FAIRFix to their investors on the FRN but submit a non-competitive order to receive FAIRFix at the start of each coupon period, thus transforming their FAIRFix exposure to the in arrears accrual rate which they would pay out according to swap market conventions (e.g. T+0 for SONIA, T+1 for €STR, T+2 for SOFR).

This action would increase non-competitive demand at the auction and thus increase liquidity in the underlying ARR OIS market.

What if a FRN investor wanted an overnight in arrears accrual?

Not a problem.. they could simply submit a non-competitive order to pay FAIRFix at the start of the coupon period (against the FAIRFix coupon that they are receiving on the FRN), thus transforming their FAIRFix exposure to the in arrears accrual rate which they would receive in according to swap market conventions (e.g. T+0 for SONIA, T+1 for €STR, T+2 for SOFR).

This action would increase non-competitive demand at the auction and thus increase liquidity in the underlying ARR OIS market.

What happens if a market maker knows that there will be a large non-competitive order in the auction?

If a customer does a large deal with a sell-side institution in a FAIRFix derivative, that sell-side institution might have a reasonable expectation that the resultant FAIRFix auction will be dominated by this position. They might therefore choose to “front-run” the auction by paying or receiving in the normal OIS market in the run up to the auction.

However, this situation is no different from new issuance deals where clients obtain pricing from the Flow Derivative desks at banks and traders have prior knowledge of what a customer is going to do. To handle these issues, customers may sometimes insist on no pre-hedging clauses and banks have controls in place to make sure traders offer best execution.

Furthermore, unlike for the aforementioned new issuance flows, these orders are not filled directly by the bank, but in a competitive auction process and there is no guarantee that they will transact and neutralise their “front-running” trades.

What happens if the derivative exposure to FAIRFix is not known exactly.. do you still need to submit your fixing risk?

No.. only those derivative exposures that are known, need to be submitted. The main purpose for the condition on derivatives to have one party submit the fixing risk from the deal is so that there are no conflicts of interest on that party and they can thus take part in market making at the auction. If the exposure is not known, there is thus no conflict of interest.

How do we guarantee that there is enough competitive liquidity to satisfy the non-competitive demand?

Market Makers will sign up to provide liquidity at the auction. Then normal supply and demand conditions will ensure that they are always incentivised to provide sufficient liquidity. This is because the non-competitive orders can trade at any price. Therefore if the supply of competitive liquidity starts to drop at the auction, the clearing price of the auction will tend to settle slightly further away from the pre-auction mid market price. Competitive forces (i.e. the profit motive) will then encourage other market makers to start adding competitive liquidity to the auction in order to profit from this extra margin until an equilibrium level is found.

In addition, at the outset of the FAIRFix regime, market makers will commit to providing sufficient liquidity with sufficiently tight bid to offer spreads to ensure that all possible anticipated non-competitive liquidity is able to find reasonable competitive bids and offers.

What happens if there is still insufficient liquidity?

If there is insufficient liquidity at the auction, the auction administrator will solicit the market makers to submit more liquidity. At no point will they indicate the size or direction of the non-competitive orders. In addition they can run a supplementary auction to fill the entirety of the non-competitive orders. In the event that there are still insufficient competitive orders, some of the non-competitive orders will only be partially filled. If there is a larger notional of non-competitive bids than offers then, all the offers will still be filled (or vice versa if there is a larger notional of offers) and all the non-competitive bids will be partially filled in the same ratio. The actual percentage will be dependent on the notional of non-competitive orders, the total size of the order book and the shortfall of competitive offers.

Will this create a conflict of interest for market makers?

No.. not unless they knew, before submitting their competitive prices, that the auction would fail, which way round the net demand (of non-competitive bids and offers) was, and what the resultant ratio of fills to partial fills would be. Therefore it is extremely unlikely that this would create a conflicts of interest.

What would you need to do if you received a partial fill on your non-competitive order at the auction?

If, for example, you had submitted an order to pay FAIRFix in 3 month SOFR in $100 million but only transacted 80% at the auction, you would be left with a shortfall of $20 million that you might choose to hedge by paying in the regular broker market.. however, you could choose to do nothing as there would be no conflict of interest as the FairFix rate would have already been set.

Is there a fallback for FAIRFix if there are no competitive bids and/or offers?

Yes, there is a waterfall methodology for determining a fixing rate for all eventualities. If you would like more information please contact Alaistair Sharp by sending an email to info@fairfix.co.uk or just click the contact us link.

Are FairFix swaps suitable for centralised clearing?

Yes.. unlike for other term fixing methodologies, FAIRFix term-fixed ARR swaps would be priced on the same interest rate curve as regular ARR OIS swaps and so would be suitable to clear for all the tenors that the regular OIS swaps clear. This is because they are economically fungible as the daily auction transacted rate is the same rate as the FAIRFix fixing.

Would there be any basis between FAIRFix derivatives and regular OIS?

No, there shouldn't be. Any basis between the two would be due to issues such as CCP basis rather than projected rates. As the FAIRFix fixing rate is the same rate that you transact an OIS at the auction, you can switch from exposure to FAIRFix and to exposure to the overnight in arrears accrual, and so both are economically equivalent.

This is distinct to current plans for term rates, where, if derivatives are allowed to develop, a basis would inevitably ensue due to a divergence in projected rates (as you could not ensure that you could switch seamlessly between exposure to the term fixing and the overnight in arrears accrual). This divergence would lead to a fragmentation of liquidity which will not be present in FAIRFix derivatives.

Are FAIRFix fixings robust?

Yes.. as the FAIRFix auction swaps exposures to the term fixing over to the realised rate (or vice versa), the FAIRFix fixing rate is economically equivalent to the realised rate and thus underpinned by the same volume of transactions that underpins the overnight ARR fixings.

For more information please refer to the link on Robust Fixings.

Will FAIRFix rates be IOSCO compliant?

FAIRFix rates are transparent transaction based rates that reflect genuine supply and demand conditions and so should be compliant with IOSCO principles for financial benchmarks.

Would there be any issues if legacy deals referenced FAIRFix?

None at all.. on the contrary, it would boost liquidity in ARR markets and make the fixings even more robust. All parties with legacy deals that referenced FAIRFix would be able to make payments on schedule (even for in advance payments on deals such as caps, floors and FRAs) and there would be no IT or system headaches issues with devising an accrual methodology that was fair and worked for all use cases.

This would not introduce conflicts of interest as one of the conditions of being a market maker at the FAIRFix auction is that they all neutralise their fixing exposures and thus all a market maker would need to do would be to submit any fixing exposure derived from their legacy portfolio to the relevant auction. This would provide an instant boost to demand side liquidity that would incentivise market makers to further increase the supply of competitive order liquidity.

Particularly in the case of deals that are contracted to pay in advance (and are therefore not able to handle a realised in arrears rate), FAIRFix will allow legacy deals to make payments without the need for time consuming (and potentially fruitless) contract renegotiation and thus would benefit both end users, who need a term rate, and sophisticated market participants, who are happy to transition to overnight (compounded in arrears) realised rates.

How would Flow Derivatives desks benefit from FAIRFix?

Flow Derivatives desks make their money from risk managing the deal flow of their customers from zero to 50 years. While on a macro level these deals can net off, the desk is left with a mismatch in their daily fixing exposures that they need to manage.

Currently they have two options to manage these mismatches. . Ideally they would hedge opposing fixings either through a Forward Rate Agreement (FRA) matching service such as Reset or TPMatchbook, or through the Over The Counter (OTC) broker market. Failing that they might attempt to mitigate their daily fixings with interest rate futures or other OTC deals. The problem with both of these is that there is a cost, both financial and in the time they need to dedicate to this activity.

FAIRFix removes this cost by allowing Flow Derivatives desks the ability to perfectly hedge their fixing exposures in the daily FAIRFix auction. This due to the fact that the FAIRFix rate is the same rate as at which they transact their hedging OIS deal. The FAIRFix auction essentially transforms their exposure to the term fixing into an exposure to the compounded in arrears overnight fixing rate, which matches off against regular OIS deals.

Even if customers want to deal ARR swaps with an overnight accrual rather than a term fixing, any such deals that hedges a cash market deal (that has an overnight accrual) will likely have a “fudged” accrual which uses the incorrect accrual dates (e.g. a “lookback”, “observation shift” or “lockout period” for their accruals) that would not match the regular OIS market accruals and thus would introduce a cost that the desk would have to charge the customer for. FAIRFix would remove the need to have incorrect accruals and thus remove this cost.

How would Short Term Interest Rate Trading (STIRT) desks benefit from FAIRFix?

In general, STIRT desks would be the desks that were the market makers for the FAIRFix auction. In general their customer base tends to be very price sensitive and there is a predominance of speculative accounts. Unlike in the medium term swap markets traded by Flow Derivatives desks, there is very little non-price sensitive flow in STIRT markets. With FairFix, end user derived interests would enter the market in the same way that it does in medium term markets, thus providing, for the first time ever in STIRT markets, demand that is non-price sensitive. This is precisely the demand that banks are looking to supply and it is exactly what is needed in nascent ARR markets to kick start the process by which liquidity will develop to the level of current IBOR markets.

This is distinct to the current Central Limit Order Book (CLOB) model for deriving SONIA term rates, where all participants are price sensitive and all orders are competitive, and thus almost no transactions occur (nor are likely to ever occur in the fixing window).

In addition, and much like for the above CLOB model, these market makers will also receive commercial incentives (e.g. such as a revenue share in FAIRFix) that will encourage them to participate and commit to providing liquidity.

Can Cross Currency (XCCY) basis swaps reference FAIRFix?

Yes, they can. The fixing exposures from both legs of the basis swap would need to be submitted to their respective auction.

What happens if both sides of XCCY basis swap are FAIRFix market makers?

They would both need to submit non-competitive orders (rather than just one side in the case of a sell-side to buy-side deal) to the auction. The orders would obviously net off but this would still be required to ensure that all market makers neutralised their fixing exposures.

The FAIRFix basis swap would still facilitate XCCY basis swap transactions as it would allow for the interest and the principal to be repaid on the same day, matching real world transactions, while also allowing parties to accrue interest correctly, matching off against the Foreign Exchange (FX) Swap market transactions that are often used to manage FX cash balances. The FAIRFix basis swap would thus reduce the cost of swapping interest rate exposures from one currency to another with respect to ARR basis swaps that used one of the incorrect accrual methodologies (e.g. “lookback”, “backward shift” or “lockout period”).

It would also allow for a seamless transition to ARR on one leg of a deal while the other leg of the deal remained on an IBOR rate (e.g. EURIBOR), thus removing the need to wait for other currencies to transition.

Will the submission obligation present a compliance issue?

There will be compliance issues with the submission obligation, but they are not likely to be large. The obligation is not a strict liability as it is on a “best efforts” basis. Thus if your systems had incorrect data and you submitted the wrong order that would not be an issue.

This would not create a conflict of interest as you were not aware of the error and so would not be acting in. Thus compliance should not view the obligation as very onerous.

And in any case, any compliance issues would certainly be lower than those that arise from current issues with IBOR transition (e.g. conflicts of interest from ARR fixings) and the general costs of transitioning to a world without a viable term fixing for ARR (cf. there is no plan for a SARON term fixing).

Will the rate fluctuate wildly?

It shouldn’t fluctuate more than regular ARR markets as the auction puts all market makers in competition for the non-competitive demand at the auction. As the auction facilitates the process by which end user interest can enter price discovery, this is a more desirable market place for market makers than current OIS markets, and so they will be willing to provide better liquidity that they might currently provide.

However, it is certainly possible that it could fluctuate in extreme markets. This is no different though to LIBOR which has fluctuated daily by ~ 10 bps during the volatile markets of of March and April 2020 caused by Covid-19 lockdowns and by ~ 30 bps during the GFC in 2007 and 2008.

Will derivative notional increase as a result of FairFix auction transactions?

Derivative notional will increase, though compression services should be able to reduce the costs of this. In addition, the added cost of this is unlikely to be large due to the short term nature of the transactions and in any case will be significantly lower than the cost of transitioning financial markets to a world without a viable term fixing rate for ARRs.

What if non-competitive orders net off to zero?

In practice, once the auction has been up and running for a while, this is extremely unlikely to happen. But if it does this is not a problem.. the mid-market rate of the competitive bids and offers would be used for that day’s FAIRFix auction transactions.

How will FAIRFix promote IBOR transition?

FAIRFix will permit the simple replacement of IBOR fixing rates with comparable ex-ante (e.g. set in advance) term rates. It will thus remove many of the barriers to transition that end users are currently having to grapple with. Additionally, the derivative obligation promotes liquidity in the underlying ARR OIS markets ensuring that will be liquidity available to transition end users away from IBOR rates.

For more information please refer to the link on Promoting IBOR Transition.

What is the organic molecule in the background on the “Overview of FAIRFix” page?

It is Kevlar.. strong and bullet proof.

Who should I contact if I am interested in using FAIRFix or if I have any further questions?

You should contact Alaistair Sharp by sending an email to info@fairfix.co.uk or just click the contact us link.

FAQs

Do we need term fixings?