FT Alphaville " Ronia to the rescue Or, what to do when your primary funding benchmark is in crisis. The search is on in money markets for an alternative to Libor, amid doubts about the rate's reflection of banks" actual borrowing costs. So it seems a fortuitious coincidence that April this year will see a boost to the recently launched Repo Overnight Index Average (RONIA) as one such alternative. Ronia's a secured rate. Unlike Libor, which emerges from a survey that asks banks "At what rate could you borrow funds etc.." Ronia is also derived from actual transactions. Ronia will become an official fixing for a brand new Overnight Indexed Swap (OIS) market in Britain. Icap has just produced a major note on the upcoming transition. As they explain, the fixing is expected to run parallel with the market which exists for Sonia, the unsecured overnight equivalent. A group of banks, meanwhile, have promised to make a market in the Ronia secured rate so as to ensure the market's independent development and liquidity. If you're wondering how the Ronia market will differ from the established Sonia and Libor ones, here's a useful comparison table from the Icap's Don Smith (click to enlarge): As with the Sonia rate, Ronia will be derived from the weighted average of eligible transactions conducted in the trading day. Unlike Libor, however, the rate will only tabulate one-day funding conditions - since liquidity becomes an issue for weighted transaction averages beyond that point. So why does that market need Ronia? Here are some thoughts from Smith (our emphasis): The Sonia swap market has become a hugely important vehicle for hedging exposure of banks and non-banks to movements in overnight unsecured rates. Given that the BoE's money market operations aim to keep unsecured cash rates in line with the Bank Rate, Sonia has become a useful hedging tool against BoE policy changes, this reflected in the fact that, although the forward market in OIS swaps started trading on a monthly calendar basis, it now largely trades on an MPC meeting dates basis, in that contracts are matched against MPC meeting dates. Sonia has also become an important hedging instrument for trading activity (particularly gilts), based on the fact that Sonia swap rates are very closely correlated with risk-free (as the overnight maturity which they reference is regarded as being close to risk free). Sonia's usefulness as a hedging tool is enhanced by the fact that much trading activity is typically financed on an overnight basis and the SOnia swap offers protection against volatility in overnight cash rates. However, traders typically use the repo market for funding of gilt positions because of ease of access and efficiency of transactions in this market. And while a Sonia swap protects against variance in unsecured rates, it does not specifically protect against variance in repo rates. So, one might assume, while it was good using Sonia as a reference for repo deals when the unsecured (risk-free) rate ran parallel with the repo rate, ever since divergence between secured and unsecured rates - even on a one-day basis - started to become a reality, an element of basis risk has entered the market. With that has come demand for a new hedging instrument which can tabulate that basis risk. Another point worth making is that Ronia will capture overnight repo rates only for "run-of-the-mill" AAA government debt (gilts), provided via the "delivery-by-value" (DBV) process. Banks who lend based on overnight gilt collateral will therefore receive any old gilts as long as they meet a set market value, rather than getting a specific gilt issue. That means Ronia's DBV will exclude so called "special" or hard to get gilts, and see the cheapest collateral delivered instead, says Smith. A real risk-free benchmark As Smith also notes, given that the DBV process is overseen by a central counterparty clearing agent, overnight DBV repo transactions can be considered the nearest thing to a risk-free rate in the market. In theory therefore, as long as there is sufficient DBV collateral in the market, Ronia should be as close as one can possibly get to a market measure of risk-free overnight rates. As for that basis risk between Sonia and Ronia, here's how volatile it can get: That last chart, we think, is particularly compelling - and possibly explains why the BoE decided to act ahead of the curve on collateral availability, since the overnight repo rate had clearly started to take on the characteristics of a "special" rate. Meanwhile, if you think Ronia will never fully takeover from Sonia, it's worth taking a good look at this chart. As can be seen, Sonia volumes are now less than half their pre-crisis levels (a reflection of the vapourisation of unsecured lending that's taken place since the crisis): Which brings Smith to another excellent point, the effect of all this on who and what is influencing the overnight rate market. After all, while the Libor market is strictly the domain of the interbank community, a much wider category of institutions can participate and influence the overnight repo lending markets (even if it's just the banks that are submitting quotes). As Smith notes: The influence of non-bank-dominated broker flows on the Sonia measure fix seems to go a long way towards explaining why it consistently fixes lower than overnight Libor (which is specifically an interbank measure). It also explains why Sonia can fix well below the Bank Rate (at which banks can source funding from the BoE). Because a great deal of the flow in the Sonia measure is from entities with no direct access to the BoE, the banks can bid for these deposits at much lower rates than the interbank market. This, we think, is a hugely important point. First, it shows to what degree overnight rates represent the "real" funding rate and second, it explains why the Bank of England is having so much trouble influencing the wider market. After all, the BoE can support the banks it seems, but it can't stop the wider market from suffering the ever diminishing returns associated with plunging overnight repo rates. Of course, if a market in Ronia was to kick off, it could create a workable benchmark for the Bank of England to finally target. With that, you could see a lot more (reverse) repo operations by the central bank. Which, of course, would be kinda similar to the recent speculation we've heard about what the Fed might do next. Related links: A central bank is only as good as its target - FT Alphaville Can Libor be saved? - FT Sterilised QE - FT Alphaville Series This entry was posted by Izabella Kaminska on Thursday, March 8th, 2012 at 13:57 and is filed under Capital markets. Tagged with bank of england, Libor, repo rates, Ronia, sonia.