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Learning Curve: ICE Swap Rate is a model for benchmark reform

Trading stock interest rate index adobe stock 230x150 AS

The breakdown of trust in ISDAfix following allegations of collusion and manipulation in 2012 led to a complete overhaul of the benchmark. A recent report by the Financial Conduct Authority proves that the hard work is paying off, reaffirming the potential for the model to be applied to other benchmarks.

By Dan Marcus, CEO of Trad-X, and member of the ICE Swap Rate oversight committee.

Benchmarks are fundamental to the functioning of modern financial markets. If structured, regulated and used appropriately, they can reduce transaction costs and increase liquidity to the benefit of all participants.

This wasn't always the case with ISDAfix. Allegations of misbehaviour thrust the interest rate swaps market into the spotlight a few years ago for all of the wrong reasons. 

Dan Marcus tradition
Dan Marcus, CEO of Trad-X.

Driven by the need to restore confidence in financial markets, the calculation methodology of the ISDAfix benchmark underwent an overhaul. The advent of more stringent regulation, combined with widespread adoption of electronic trading in interest rates swaps, laid the foundation for a more reliable and accurate data reference methodology.

In March 2015, ISDAfix became the regulated ICE Swap Rate, administered by the ICE Benchmark Administration. It now aggregates streams of actual order data provided by multiple multilateral trading facilities (MTFs), transforming it from a submission-based benchmark, to one based on firm orders. 

The FCA recently published its evaluation of the effects of bringing a number of additional benchmarks into the regulatory and supervisory regime.

Based on data from Trad-X, a material provider of orders for the ICE Swap Rate, the regulator conclusively found that the combination of methodological and regulatory changes made the benchmark less vulnerable to manipulation, tightened spreads and significantly reduced trading costs.

A regulator’s view of benchmark reform

To understand whether the benchmark represented the underlying market, the FCA measured the gap between the benchmark rate and the average buy and sell price around the benchmark assessment time.

It found that the changes improved the representativeness of the ICE Swap Rate by 12%-68% depending on the time window used to estimate the difference. This is a huge step forward for the transparency and accuracy of the benchmark.

To analyse the effects on the underlying market, the FCA also examined liquidity and trading costs. The report shows that the average daily time-weighted spread decreased by 14% and the average daily time-weighted relative quoted spread dropped by 11%. 

Meanwhile, the sum of the offer and bid volumes at the best 10 levels of the order book marginally increased by approximately 4%. Looking at trading costs, the report shows that the roundtrip costs for completing a buy and sell transaction decreased by 11%, meaning the overall cost savings plausibly amount to £46.8m

These statistics illustrate a dramatic improvement in the representativeness of the ICE Swap Rate versus its predecessor and the quality of the underlying market. They are also a testament to how moving a benchmark to a firm order-based methodology can restore confidence, improve the integrity of financial markets and ultimately lead to better financial products.

Benchmark for benchmarks

Unfortunately, other benchmarks continue to struggle with efficiency and transparency challenges. Libor, for example, is a critical benchmark for the interest rate market, but it continues to be based on an indicative survey from a panel of banks. 

The FCA has made it clear that investors need to reduce their reliance on Libor and transition towards other benchmarks after the end of 2021. In the age of electronic trading, big data and algorithms, where a more suitable alternative can be provided, market participants should not have to rely on reference rates based on submissions which do not have active underlying markets to support them. 

When you look at building up liquidity in Sonia — which the FCA has identified as a replacement to Libor — you need to find an intelligent way to create a mid-swap. There is a clear argument that the calculation methodology for the ICE Swap Rate can be adapted and re-tooled to meet the requirements of traders seeking to utilise Sonia. 

In effect, it has set the new benchmark for benchmarks.