The CDOR chronicles: Roll-out of a term-based benchmark replacement rate on track for Q3

The Canadian Alternative Reference Rate working group (CARR) continues to lay the groundwork for the adoption of the Canadian Overnight Repo Rate Average (CORRA) by providing 1- and 3-month Term CORRA rates. However, these rates will be restricted to particular financial products in an effort to curb financial market fragility.

What you need to know

• On January 11 CARR announced its expectation that 1- and 3-month Term CORRA rates will be available for use by the end of Q3-2023, well ahead of the CDOR sunset date of June 28, 2024.
• In order to extrapolate term rates from an overnight rate, a yield curve must be constructed based on 1- and 3-month CORRA futures trading on the Montréal Exchange (reflecting the market’s forward projection of what interest rates will be for the corresponding periods).
• The use of Term CORRA will be restricted to trade finance, loans and derivatives associated with loans through licensing agreements available at a “commercially reasonable cost” for the purpose of constraining the use of Term CORRA to those counterparties that have a real commercial need for the rate.

Background

• Because of the LIBOR manipulation scandals nearly a decade ago, global loan markets have been moving away from interbank offered rates (IBORs) towards so called “risk-free rates” (RFRs), which are more stable and resilient during credit shocks, such as the 2008 financial crisis and the initial COVID lockdowns in the first half of 2020.
• Among the shortfalls of interbank rates, including the Canadian Dollar Offered Rate (CDOR), are their inherent reliance on human forecasting and susceptibility to manipulation¹.
• Following a public consultation initiative in May 2022, CARR² published in August 2022 its recommended fallback language which provides a contractual framework for CDOR-based financial products to transition off CDOR to a risk-free rate of CORRA.
• CORRA is an overnight risk-free rate administered by the Bank of Canada that measures the cost of overnight general collateral funding in Canadian dollars using Government of Canada treasury bills and bonds as collateral for repurchase transactions³.
• Currently, the CORRA rate is only available as a daily rate, whereas the CDOR rate it is replacing is published in term rates, most typically for 1-month and 3-month terms.

Term CORRA benchmark rates available in Q3-2023

The January 11 announcement confirms that 1-month and 3-month Term CORRA benchmark rates are expected to be available for market use by the end of Q3-2023, ahead of the CDOR sunset date of June 28, 2024. In order to extrapolate a term-based cost of funding from an overnight cost of funding, a forward-looking yield curve will be constructed using CORRA interest rate futures traded on the Montréal Exchange. The Montréal Exchange is an affiliate of the Toronto Stock Exchange (TSX) and is the sole venue for listed interest rate derivatives in Canada.

CARR has determined that the derivation and management of the CORRA rate will be administered by CanDeal Innovations Inc. (CanDeal) in conjunction with TMX Datalink, the information services division of the TSX. Under this structure, the view and expectation that Term CORRA rates will be developed and implemented in a manner that complies with the International Organization of Securities Commissions Principles for Financial Benchmarks (IOSCO Principles). CARR expects that both Term CORRA and its administrator will be regulated by the Ontario Securities Commission and the Autorité des marchés financiers under Multilateral Instrument 25-102, Designated Benchmarks and Benchmark Administrators (MI 25-102). Among other requirements, MI 25-102 mandates the benchmark administrator to have an oversight committee independent of the benchmark administrator to oversee the provision of Term CORRA, including any changes to the calculation methodology⁴.

Pay-to-Play

Entities that provide or originate financial products referencing the Term CORRA benchmark, or those that redistribute it, will be required to enter into licensing agreements with the TMX (or an affiliate) in order to gain access to the real-time published benchmark rates. Access to the licensing agreements and published rates by market participants will be subject to payment of a licensing fee at a commercially reasonable cost.  However, Term CORRA will be available for free viewing on either or both of the CanDeal and TSX websites on a delayed basis.

The licensing agreements will prescribe the classes of financial products permitted to use Term CORRA as a reference interest rate, namely loans and derivatives associated with loans, similar to Term SOFR. (See table below for reference⁵.)

End-users of Term CORRA products (e.g., corporate borrowers) will not need to have a license through to the CDOR sunset date (June 28, 2024) but must agree to standard terms and conditions of use. After June 28, 2024, end-users may also be required to enter into licensing agreements, which is currently under consideration by CARR⁶.

Restrictions on usage of Term CORRA rates

CARR’s intended purpose for requiring a licensing agreement—and payment of the associated licensing fee—in order to access real-time Term CORRA published rates is to constrain the number of market participants that reference Term CORRA in their financial products. The expectation is that most of the floating rate interest products in the market by notional and/or principal size will continue to use a daily overnight CORRA rate.

The reason underpinning these constraints to limit the use of Term CORRA stems from a principle of proportionality stipulated in the IOSCO Principles which is concerned with the “inverted pyramid” issue. This reflects a lesson largely informed by the earlier LIBOR scandals where there was a staggering asymmetry between the size of the London interbank wholesale market from which the LIBOR rate was derived (typically in the range of $1 billion in median daily volume) relative to the hundreds of trillions of dollars of financial instruments using LIBOR across global financial markets⁷. There is a general consensus among central banks, prudential regulators and adjacent industry participants that this level of asymmetry between rate-derivation markets and the corresponding rate usage markets introduces fragility into financial markets and should be avoided.

Replacement of the replacement rate

Notwithstanding the significant level of effort and consideration deployed by the Canadian loan market industry in arriving at Term CORRA as the best suited replacement rate for CDOR, CARR has noted that Term CORRA’s long-term sustainability is not guaranteed. Specifically, the ongoing viability of Term CORRA will depend on the liquidity of the underlying CORRA futures contracts from which Term CORRA is derived. If the depth of liquidity in these contracts does not remain sufficiently robust, the benchmark administrator will be required to amend its rate-derivation methodology⁸.

In that regard, the CARR recommended fallback language for CDOR-based loans contains mechanics for loan counterparties to determine a subsequent benchmark replacement in the event Term CORRA is no longer available or representative of the economic cost of borrowing.

A final word on ISDAs

Market participants engaged in loan facilities with accompanying interest rate hedges should be mindful of avoiding the potential for introducing basis risk between the reference rate on the underlying loan exposure and the reference rate under the corresponding interest rate swap. The potential for basis differential is more of a concern for LIBOR-based loans transitioning to SOFR because the related LIBOR fallback language permits counterparties to make the transition at any time prior to the LIBOR cessation date, whereas the CDOR loan market is binary in that all CDOR loans will toggle to CORRA concurrently on June 29, 2024. Similarly, all CDOR derivatives subject to the International Swaps and Derivatives Association (ISDA) 2020 fallbacks protocol or the ISDA 2021 Interest Rate Derivative Definitions, will be converted to a rate based on overnight CORRA following the cessation of CDOR on June 28, 2024.

Borrowers that wish to hedge Term CORRA loans with Term CORRA derivatives could see higher hedging costs than if they were using overnight CORRA for both their loan and their derivative hedge. This is due to the one-sided nature of the hedging demand from bank loan end-user clients. The higher hedging costs would be in the form of a positive basis (additional spread relative to overnight CORRA derivatives), similar to that seen in the Term SOFR derivative market. To encourage a more balanced market for Term CORRA derivatives, CARR will include lenders’ Term CORRA hedging transactions in the approved Term CORRA derivatives use cases⁹.

Please feel free to reach out to the author should you have questions or if you wish to discuss the CDOR transition generally.