Why Canada may need to revisit term Corra methodology

Break from US guidance benefits dealers but some futures inputs underpinning term rate are in short supply

When Canada began the process of reforming its legacy interest rate benchmark – the Canadian dollar offered rate, or CDOR – it was widely expected to follow the blueprint used to transition the US market away from Libor. 

And it has – with one major twist.

The most striking difference is the official acceptance of interdealer trading in derivatives referencing a term version of the replacement risk-free rate – the Canadian overnight repo rate average, or Corra. 

The US authorities placed strict curbs on the use of the term version of the secured overnight financing rate, or SOFR. The use of term SOFR derivatives was limited to end-users hedging cash products. Interdealer trading was banned on the grounds that such activity could cannibalise volumes in the overnight instruments that are used to construct the term rate. 

Where Canada was unique or different, we were not shy to forge our own path

Karl Wildi, CIBC

The Canadian Alternative Reference Rates working group (CARR) – the industry body tasked with transitioning the market away from CDOR – has taken a different approach. Swap dealers in Canada will be allowed to offset the residual risk that remains on their books when customer-facing term Corra exposures are hedged with overnight index swaps by entering into basis trades with other dealers. 

“Where we could be consistent with global conventions, we sought to do so. We recognised that lenders, borrowers and hedgers operate across borders, so standardisation would be desirable. But where Canada was unique or different, we were not shy to forge our own path,” says Karl Wildi, managing director at CIBC and co-chair of CARR. 

While the move has been welcomed by Canadian banks, questions remain over whether liquidity in the instruments underpinning term Corra is sufficient to support an interdealer market in derivatives referencing the rate. As of the end of January, open interest in one-month Corra futures – a key input for the term benchmark published by CanDeal and TMX – was languishing at just 519 contracts. A large over-the-counter swaps market – estimated at around C$50 billion ($37 billion) – resting on such scant volumes could suffer from the same so-called inverted pyramid problem as Libor, where a rate derived from a relatively small base of transactions was used to price $200 trillion of derivatives contracts. 

Regulators are watching closely to see whether liquidity in one-month Corra futures will improve as the loan market switches to the new benchmark ahead of the June 28 deadline for shutting down CDOR.   

“If this is not the case, CanDeal and its oversight committee might have to review the term Corra methodology to ensure it remains robust,” says Harri Vikstedt, senior policy director for financial markets at the Bank of Canada and co-chair of CARR. “But at this point everybody’s expecting that we’re going to get some traction in the one-month contract.”

Smooth operation

The lack of liquidity in one-month Corra futures is one of a handful of road bumps in what is otherwise shaping up to be a smooth transition away from Canada’s legacy interest rate benchmark. 

Total CDOR exposure, which stood at around C$20 trillion in late 2020, has declined sharply over the past three years. Exposure to cleared CDOR swaps has fallen from C$16 trillion to around C$9 trillion, with more than C$7 trillion notional now referencing Corra, according to data from LCH, the primary central counterparty (CCP) for Canadian dollar swaps.   

“From a liquidity standpoint, Corra has really taken over as the dominant benchmark. And from that standpoint, I’d say the transition has gone well,” says Andrew Kelvin, Canadian rates strategist at TD Securities.

Corra swaps trading overtook CDOR volumes in mid-2023, with data from CARR and London Stock Exchange Group showing that instruments linked to the new benchmark represented more than 90% of traded risk – or DV01 – in Canadian dollar swaps in the week ending January 19.

CanDeal and its oversight committee might have to review the term Corra methodology to ensure it remains robust. But at this point everybody’s expecting that we’re going to get some traction in the one-month contract

Harri Vikstedt, Bank of Canada

The non-cleared market has also been making good progress. The vast majority of Canadian dollar legs on cross-currency swaps have referenced Corra since March 2023, when CARR’s ‘Corra first’ initiative was extended to non-vanilla rates products, including swaptions and cross-currency instruments. 

Canadian CCPs will dust off their Libor playbooks to convert the remaining stock of cleared CDOR swaps to the new benchmark. Contracts will re-hitch to a compounded version of Corra with spread adjustments calculated using a methodology devised by the International Swaps and Derivatives Association. CME, which clears C$164 billion notional of Canadian dollar-denominated swaps, will go first with a primary transition on May 17, while LCH will convert an estimated 100,000 contracts with total notional of C$9 trillion over the weekend of June 8–9. 

The CCP exercise is a fraction of the size of the US conversion, which saw LCH flip 600,000 contracts with $45 trillion notional to SOFR, while CME handled another $4 trillion of trades. 

Vikstedt at the Bank of Canada acknowledges that broad adherence to the tried-and-tested US template and the contained nature of CDOR have made it easier to move away from the outgoing benchmark. “Having a more limited scope and coming after the Libor transition to get guidance on best practices has been very helpful,” he says.  

In some cases, CARR has taken a stricter stance than its US counterpart. For instance, the Canadian loan market sidestepped the cumbersome negotiations associated with the so-called amendment approach for loan fallbacks and instead moved straight to hard-coded language. 

“With US credit facilities, you saw amendment after amendment creating different iterations of the fallback. We skipped all of that and went straight to hard-coded fallbacks, which really did a favour to the loan market,” says Lisa Mantello, partner at Osler, Hoskin & Harcourt and a member of CARR.

In other areas, most notably use cases for a forward-looking version of Corra, the working group has taken a more flexible stance.

Term divergence

The final set of approved use cases for term Corra released by CARR in August 2023 includes interdealer trading by bank treasuries seeking to hedge their term Corra basis risk with other swap dealers. 

This activity is strictly outlawed in the US, where use of term SOFR derivatives is limited to direct hedging of term SOFR cash exposures by end-users. 

This approach has its downsides. The ban on interdealer trading has created a one-sided market in which term SOFR swaps trade at a premium to compounded-in-arrears versions, with limited transparency into pricing. 

CARR’s reason for taking a more flexible position on interdealer trading was largely to improve the capital treatment of term Corra swaps. In the absence of observable prices on interdealer screens, term SOFR swaps on dealers’ balance sheets are typically classified as Level 3 assets under international financial accounting standards, meaning banks must hold more capital against them.

“The capital-level categorisation was part of that decision,” says CIBC’s Wildi. “Also, we wanted to ensure bank treasuries, who will have the offsetting risk to dealers, are able to access any Canadian dollar swap dealer to hedge their term Corra exposure. This will enhance transparency, market function, and allow risk to be recycled efficiently.” 

While pricing transparency could be met simply by banks streaming their own bid and offers for term Corra swaps via Bloomberg, at least one interdealer broker is understood to be modelling term Corra curves with the intention of launching an order book for term Corra swaps. 

Still, Wildi expects term Corra use to remain limited. The main rationale for the US ban on interdealer trading of term SOFR swaps was to promote liquidity in the overnight rate.  

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Wildi estimates the C$220 billion of CDOR-related loan exposures as of late 2020 were hedged with roughly C$50 billion notional of swaps. Even if all of this moves to term Corra, it will still be a fraction of the $20 trillion notional referencing overnight Corra post-transition. 

“We felt it was a manageable risk and one worth taking for the advantages it would bring,” says Wildi.

Only a handful of term Corra swaps have traded to date, with notional of just C$59 million, according to data compiled by Risk.net. These are not thought to be interdealer trades. 

Allowing interdealer trading in term Corra is unlikely to fully quash any basis between the overnight and term swaps, he adds, meaning there will still be an incentive to use the former. 

“We presume, based on the experience in the US, that there is going to be a basis and we are fine with that,” Wildi says. 

The likely cost difference means overnight Corra swaps should remain the preferred instrument for hedging loan exposures, Vikstedt says. “As people get familiar with using an overnight rate and realise the cheapest hedging option is the RFR, they’re going to do that,” he explains. “It may also be operationally beneficial to use a single rate for all your lending and hedging activities. And if it’s going to be cost effective, why wouldn’t they?”

Trouble in the futures?

The big risk is that the term Corra benchmark will not be robust enough to support a swap market that includes interdealer trading. While TMX-listed three-month Corra futures had open interest of more than 730,000 contracts at the end of January – compared with just over 400,000 for comparable CDOR contracts – the one-month version has struggled to find demand, with open interest of just over 500 contracts and average daily volume of just 22 contracts for January.  

This is a problem because loans – and the swaps used to hedge them – typically reference a one-month term rate. 

The Bank of Canada’s Vikstedt is optimistic that trading in the one-month futures contract will gather pace as more loans are hitched to the successor rate, as has been the case in other benchmark transitions.  

I’m confident we should have enough activity in the one-month and not have to revisit the way it’s calculated

Luc Fortin, Montreal Exchange and TMX Group

“In all Libor jurisdictions liquidity went into the three-month RFR futures. That was expected and it has also been true in Canada. But as bank treasuries start building exposure to one-month term Corra as a result of the loan market transition, we expect you’ll get more liquidity in the one-month Corra futures,” says Vikstedt. 

In the US market, CME-listed one-month SOFR futures remain a fraction of the three-month contract. Open interest in the shorter-dated instruments stood at 861,000 as of February 6, compared to more than 10 million contracts in the benchmark’s three-month tenor. In the UK, one-month futures tied to the sterling overnight index average, or Sonia, failed to get off the ground, with no open interest in the Ice-listed instruments as of February 6 compared with 1.9 million in the three-month tenor.

If liquidity fails to develop in the one-month futures contract, it could force TMX and CanDeal to consider alternative methodologies for the term version of Corra. One option could be to turn to the swaps market. While CME’s term SOFR benchmark tracks futures linked to the overnight rate, Ice Benchmark Administration’s term Sonia rate references the overnight index swap market.  

The term Corra providers insist a change in methodology won’t be necessary. “I’m confident we should have enough activity in the one-month and not have to revisit the way it’s calculated,” says Luc Fortin, president and chief executive of the Montreal Exchange and global head of trading at TMX Group. 

Fortin argues that the loan market transition, coupled with a changing rates environment, will entice more traders into the shorter-dated contract. 

“We will see more volatility in these when there’s a clear line of sight in terms of where interest rate moves can go. If there’s no interest rate movement, the one-month is not going to trade actively. As we embark on this, we’ll start to see a lot more volatility in the one-month versus the three-month, so from a timing perspective it’s good.” 

But if one-month futures volumes fail to materialise, Canada may need to go back to the drawing board to come up with a more robust term version of its new interest rate benchmark. 

Additional reporting by Bernard Goyder