From CDOR to CORRA

Karl Wildi: So we expect what we’re guiding the market to is that towards the end of the first quarter of June 2023 is when you’re going to see the notable change in liquidity from CDOR over to CORRA. So that feeds into your question in terms of futures. We would expect the same in the futures market.

Bipan Rai: Welcome everyone to another edition of The FX Factor podcast. As usual, this podcast is available on most of the major platforms, including iTunes, Spotify and Google. This is a special edition of the podcast. It’s not every day when an important announcement is made with respect to benchmark rates here in Canada. And it’s not often that we have a guest on here that was involved in the decision making process. Of course, I’m speaking to the recent announcement that Refinitiv Benchmark Services Ltd or RBSL would cease publication of the Canadian Dollar Offer ate or CDOR after June 2024. My guest today is Karl Wildi, Managing Director and Vice-Chair here at CIBC Capital Markets. Karl also serves as co-chair on the Canadian Alternative Reference Rate Working Group or CARR. CARR is a group that has led efforts here in Canada on interest rate benchmark reform. Over the coming period, CARR will support the transition from CDOR to CORRA as a key financial benchmark going forward. Karl, welcome to the podcast.

Karl Wildi: Bipan, it’s a pleasure to be here today. Thanks for inviting me.

Bipan Rai: So why don’t we start off with the basics? Can you explain the difference between CDOR and CORRA to our audience?

Karl Wildi: Happy to. CDOR and CORRA are both interest rate benchmarks, but very different in terms of how they’re constructed. CDOR, which has been around since the late eighties, is what we describe as a credit sensitive, forward looking rate. And that means that it is the rate at which a bank would offer its balance sheet against BA facilities. So it is a lending rate for a Canadian bank, whereas CORRA, which stands for the Canadian Overnight Repo Rate Average, is the clearing rate of government collateral in the overnight market. So it is what we would term as a risk free rate. And the difference in terms of CDOR being a forward looking rate versus CORRA, which is an in arrears rate. In other words, if you calculate it for three months that you are compounding the daily average for general collateral, compounding that over the three months and paying it in arrears. So in sum, CDOR, forward looking credit sensitive rate, CORRA, risk free rate, compounded paid in arrears.

Bipan Rai: Thanks, Karl. That’s a great summary. So my question then is when did and why did CDOR become untenable as a benchmark?

Karl Wildi: Well, that’s an important one, Bipan, and let me be clear on this, because we wanted to underscore in our whitepaper that CDOR, as it currently stands, is a robust benchmark. And really, we wanted to contrast what happened to LIBOR, which had definite issues through the global financial crisis that were not the same here in Canada with respect to CDOR. So there were four different frailties as we describe them in our whitepaper related to CDOR. And these frailties would potentially impact its future robustness. So as a benchmark, currently it’s functioning very well. In the future, there were risks that we identified that were potentially critical to its ongoing robustness. And I’ll summarize those just briefly. There’s four of them. The first is that CDOR relies primarily on expert judgement. This is different than global best practices, which is focused on transactions. This evolution in robust benchmarks has taken place really since 2014, with IOSCO principles and new risk free rates. The focus is going to be on transactions going forward, whereas CDOR right now relies on expert judgement. The BA model on which CDOR is based is no longer an efficient and effective way for banks to fund their loans. In the old days that you used to have a loan that a corporate would draw down on a one month reset and the bank would fund it with a one month BA security that was issued into the market. What we know now is that loans, loan arrangements are five year committed facilities in which a corporate customer may draw down on a one month tenor. The way we fund that is not in one month anymore. It’s longer term than that. So when they draw down on a one month tenor, banks actually have to hold highly liquid assets against it, which costs money. And that means that the actual level at which we lend our balance sheet is no longer the same as where one month BA securities are traded in the market. That has created what we call a basis. And that basis has been widening over time. So the connectivity between what CDOR was and what CDOR is has changed, and that sustainability of BAs as a funding tool is at threat because it is less efficient. The third area is around panel fragility and this is where ultimately LIBOR’s undoing was precipitated by banks wanting to leave the LIBOR panel. In Canada, we have six panel member banks, the six big banks. And if one or two of them ever wish to leave the panel, that would threaten CDOR as a robust rate. And so we’re highly sensitive to that as a risk because it was clearly a risk to LIBOR, and that’s what largely precipitated the move to risk free rates in the LIBOR currencies. And the last thing is that what we call the inverted pyramid, so of the BAs that are drawn down, 85 to 90% of them are one month. Ultimately, most of the risk that uses CDOR is actually three months. Most of it is derivatives, and most of that is based on three month resets. So you have this dichotomy between where most of the transactions are underlying, which is one month and most of the risk is three months. So that dichotomy or what we would call an inverted pyramid, was a risk to its future robustness as well. And those were the four that we identified in our whitepaper. And so in answer to your question, that was really the justification for looking to risk free rates and recommending the cessation of CDOR.

Bipan Rai: So that actually helps really clarify why CDOR is becoming more and more untenable, especially those four points that you made, Karl. But with respect to the CDOR market, I mean, I’m not sure our audience is aware of how large the notional value of products that are currently referenced to CDOR is. Can you walk us a bit through how large that that value is and what some of the examples of those products are?

Karl Wildi: Absolutely. So CDOR is really ubiquitous to the Canadian marketplace and large in notional size relative to the market. So there is just approximately $20 trillion of exposure that is referenced to CDOR. The lion’s share of that is derivatives. And when I say the lion’s share, I’m talking 97% of the exposure related to CDOR is derivatives. And when I say derivatives, that includes bilateral, cleared and listed derivatives or those that are listed on the TMX. Of that, let’s call it the 3%. While it doesn’t sound like a big number relative to the 97%, it’s very material to the Canadian market. So the products that are covered by those are included FRNs, loans, securitizations and deposits. And collectively all of those would add up to just under $1,000,000,000,000.

Bipan Rai: So not necessarily small amounts there. We’re talking pretty big numbers here. Now, as part of this transition, CARR has recommended, a two stage transition plan for CDOR. Stage one calls for the end of new derivatives cash exposure index to CDOR to overnight CORRA in arrears. There are exceptions to this. Can you detail what some of those exceptions are?

Karl Wildi: Sure. So stage one and stage two are unique to Canada in that we time sequenced it. We realized that following the LIBOR transition we had an advantage in that a lot of the more sophisticated market participants are able to move over from credit sensitive benchmarks to risk free rates using all of the processes and infrastructure related to the LIBOR transition. So stage one is focused on derivatives and securities. After June 30th, 2023, there should be no more new CDOR transactions in either derivatives or in cash securities, with two notable exceptions. The first is if you want to hedge a legacy portfolio of derivatives, you can do that so long as it is risk reducing. So that’s exception number one. Exception number two are derivatives associated with loans, and that could entail either pre hedging or post hedging of loan arrangements. Stage two, which we gave extra time, an extra year to the actual cessation date of CDOR on June 28th, 2024 is really for the loan market and we determined needed more time either for the development of a term risk free rate or just to implement the infrastructure and planning necessary for them to successfully transition to CORRA.

Bipan Rai: So as part of stage two, you mentioned that market participants will be allowed to transact in new CDOR based loans with fallbacks until the end of June 2024. Can you describe what the fallback is for our audience that might not be aware of what that really means and are not familiar with the jargon?

Karl Wildi: Sure, there are fallbacks that are in play in either cash securities, in loans or in derivatives. And derivatives, the fallback was set by ISDA through consultation and is consistent across currencies, and the fallback is essentially if you’ve got a three month CDOR, that it would fall back to CORRA, compounded and paid in arrears over three months, plus a credit spread adjustment. That credit spread adjustment is equal and this is where it gets a little complicated, is equal to the five year difference between CDOR and OIS, which is the risk free rate or Overnight Index Swap over the past five years. So they take that five year history, find its median, and that is calculated as the credit spread adjustment. ISDA has published that and it is published at 32.138 basis points. That will stay through time. So in other words, for every CDOR setting past June 28th, 2024, it will be, if it’s in the three month tenor, overnight Cora compounded and paid in arrears, plus the 32 basis points. That will be your CDOR setting, and that’s how the fallback works.

Bipan Rai: Excellent. So can you describe the transition in a little bit more detail? I mean, you mentioned earlier that CDOR is, of course, a forward looking term, right, whereas CORRA is an overnight rate that reflects activity that occurred, say the prior day. How can we transition from the former to the latter? It’s going to be a little bit tricky, is it not? Is there a template out there that other countries have in place that we could potentially look towards?

Karl Wildi: Well, yes, it is a little bit more complex because you’re taking daily observations and then compounding them over the period. And then the payment is relatively quickly at the end of the period, which is a big difference for people who are used to knowing their payment at the beginning of the period. So it does require a little bit more operational complexity. But for people that are in the institutional market, this has already been done through the LIBOR transition. And people have transitioned to these overnight rates, compounded and paid in arrears. And so for that group of the market, it should be relatively painless. It has required infrastructure providers to provide the functionality to do that both from a front office as well as a mid-office and downstream. But all of that has largely been built. For those in the loan market or those that have not been participants in the LIBOR transition, it will take a little bit more time and some of those companies, be they corporate or commercial, use spreadsheets, and that adds to complexity for sure. And so CARR has had feedback that a term, a forward looking term risk free rate would be highly desirable. And that is something that we’re looking at to ease the transition to risk free rates.

Bipan Rai: So another question I have for you, how will term CORRA if implemented work? I mean, the CORRA futures market is still relatively thin compared to say SOFR futures market in the United States? Will term CORRA implementation drive more activity into the CORRA futures market? Is that something that CARR has anticipated?

Karl Wildi: Well, maybe before I answer that question, I’ll talk a little bit about how liquidity will move from the CDOR derivative market into the CORRA derivative market. And so as Canada as a small, relatively small market, we are highly attuned to ensuring that we don’t have dysfunctions by having two different derivative markets functioning for too long side by side. And so the expectation is that we will, through the beginning of June 2023, seeing a wholesale shift from the depth of liquidity being CDOR based to being CORRA based. And so that will include futures as listed derivatives. And we’ve implemented two notable dates. So January 9th, 2023 is the CORRA first date and that is the date at which Canadian banks dealers will be quoting to each other in CORRA versus CDOR. Then on March 27, 2023, cross currency as well as non-linear derivatives, will be quoted as CORRA Interbank as well. So we expect what we’re guiding the market to is that towards the end of the first quarter of June 2023 is when you’re going to see the notable change in liquidity from CDOR over to CORRA. So that feeds into your question in terms of futures. We would expect the same in the futures market. There are already a strip of three month CORRA futures in the marketplace. They don’t trade a lot. The open interest is relatively low. That being said, we weren’t expecting it to take off until kind of the node of liquidity moves from CDOR underlying to CORRA underlying. So again, we expect the futures market to pick up dramatically towards the end of the first quarter of 2023. It’s at that time that we are just being, if we build a term CORRA rate that the futures market, we will look to the data that’s coming out of it to create a robust and IOSCO compliant term CORRA rate. Maybe I’ll just touch on that for a second. We have a consultation out on term CORRA right now. And so we’re really looking for, and when I say we, I mean CARR, we’re looking for the market to comment on the need for a term CORRA rate. Ultimately, we’ve had anecdotal feedback that yes, one is necessary in Canada because of its widespread use of a term rate in the US in the form of term SOFR. So we expect that we will likely need to have a term CORRA. And if that’s the case, we will create a methodology for it, which would be futures based. It will require the launch of one month futures in addition to three month futures. Those one month futures would probably be up and running by January of 2023, and term CORRA rate would likely be published from September of 2023, allowing the loan market to transition between that date and to the end of CDOR in June 2024. Of course they can transition at any time using overnight, but if they require term, then those are the timelines that the market can and should expect.

Bipan Rai: Excellent. And can you summarize for our audience what the potentially permitted uses of term CORRA are for end users?

Karl Wildi: Yes, this is going to be similar to the US where the term risk free rates are going to have a limited use case. So they are intended to be used for loans and derivatives associated with loans and that will likely be in the licensing agreement attached to that. So that is similar in the US. Interestingly, in the UK, most of the loan market has gone to overnight rates, not term rates. And we would expect, because there’s many Canadian corporations have multi-currency loan agreements with both dollars and CAD, that term refers RFRs or term CORRA will be the Canadian leg of those loan agreements.

Bipan Rai: Excellent. And this is a pretty broad question and we’ve covered a lot of ground here. But are there any potential issues or one of the most pertinent potential issues you see with this transition as we move forward?

Karl Wildi: Well, we are in pretty good shape relative to the transition. Before Refinitiv came out and produced their notice to announce the end of CDOR, CARR had already created conventions related to FRNs, both fallbacks as well as CORRA conventions. ISDA had already created its fallbacks and its methodology related to its definitions and protocols. So the derivative market is well looked after. And so ultimately we think that the stage to the end of the first stage of our transition will be pretty seamless because most of the market participants, especially those in the derivative market, are ready for this transition. And so what we think is that there will be more work to be done in the loan area. So in the second stage and some of that will be related to term CORRA, some of that will be related to educating and communicating how the transition will work and what’s important for firms to be ready for it. And the last thing I would say is the uncertainty relative to term CORRA. And one thing that is important to understand, yes, we think we can produce an IOSCO compliant term core rate. It will require ongoing liquidity and pricing, both transactions as well as bids and offers in the central limit order book for CORRA futures. And if that doesn’t continue on a sustained basis, then all market participants will have to have robust fallbacks to term CORRA should term CORRA not be able to be sustained through time. So that would be the only uncertainty I would say is related to it. But we are planning for success. But if you’re asking for things that market participants should be aware of. It is mostly around term CORRA.

Bipan Rai: And for our audience members that might have additional questions, are there any resources that they could look at or even some contacts they could reach out to?

Karl Wildi: Yes. So within the banks and if you work in a bank, then reach out to your IBOR transition team that will be in housed in each of the banks. If you’re a client of a bank, please reach out to your bank representative and they will get answers either from the product experts or from the IBOR transition team. The CARR website, it’s a tab on the Bank of Canada’s website under markets, and that has all the up to date information related to this whole transition, including the latest road map presentations, reference materials. If you have to write internal reports up regarding the transition, that would be your one stop shop for background material.

Bipan Rai: Okay, thank you so very much, Karl, for joining us today. I definitely learned a lot and I hope our audience takes a lot away from this. This is a huge event for those of us in the financial world and for market participants in general. So again, if you have any questions, please reach out to the resources that Karl mentioned. And of course, there are additional resources available on the Bank of Canada’s website. Thank you, everyone. Until next time.

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