SIBOR/LIBOR – A Hedging Perspective

The recent market disruption and volatility amid the COVID-19 outbreak have so far delivered a gloomy picture of what’s going to be next. Central banks around the globe are pledging their support to revive the sentiment. After the FED emergency 0.50% cut last Tuesday, other central banks are expected to take similar measures, specifically The European Central Bank (ECB) and The Bank of England (BOE).

SAR SIBOR/USD LIBOR Spread

Given the SAR peg to the USD, the available tools for Saudi policymakers at times are far from flexible. The Saudi Interbank Offered Rate (SIBOR) is influenced by the policy rate (Reverse Repo), which closely follows the FED rate, hence there is a spread range between SIBOR and LIBOR that is maintained. However, SIBOR is also driven by local factors such as the macroeconomic stance, liquidity, and credit, thus making the historical spread between both indices not guaranteed. Since correlations tend to break under distressing times, we started witnessing divergence between the SAR and USD based interbank rates.

Why Spread Matters

Keeping a healthy spread between SIBOR and LIBOR ensures market stability and peg maintenance. Moving outside the range creates imbalance and endorses capital volatility in or out depending on the spread being negative or positive. Looking at the past two and ten years, the spread between 3 Month SIBOR and 3 Month LIBOR has averaged 0.25% and 0.55%, respectively.

We have previously witnessed temporary dislocations, specifically in 2016, where the positive spread reached as much as nearly 1.60%. On the contrary, the Saudi central bank “SAMA” has intervened and stopped potential capital out-flows by hiking its reverse repo rate (before the FED decision) in 2018 when the 3 Month SIBOR has fallen below 3 Month LIBOR. The below graph shows the historic spread movement for the last ten years.

Graph1

Local Derivatives and Outstanding Exposure

In a significant milestone and achievement last month, the Governor of SAMA inaugurated the National Center for Registration of financial derivative data. The record-keeping of the uncleared bilateral derivative transactions would promote transparency, governance, and robust risk management by all stakeholders involved.

The recent developments of the global markets and the considerable shift of the FED stance since late 2018 have raised concerns among a few local institutions who previously took a simple view-driven approach to engage in complex derivative transactions. Such transactions can take different forms and linked to various asset classes. Specifically, the rate derivatives would be of significant concern, given the volatility and the unexpected extreme movements since early 2019.

With the 10-year US Treasury yield falling below 1.00% (historical all-time low) and fed cut the rate by 50 basis points, firms should have a thorough review of the outstanding derivative exposure and ensure their alignment with business objectives and reasonable hedging ground. Similarly, if any product proved to be more of a speculative nature, then the risk management approach should be prioritized to neutralize any further market impact and derivative portfolio deterioration. Adding to the riskiness of some products, some firms locally have either hedged or thinking to hedge via instruments that perform well only when SIBOR and LIBOR spread moves in a reasonable corridor. Others have addressed their long term exposure by utilizing a USD-based swap market, which makes them seriously vulnerable to USD/SAR swap’s divergence.

As seen earlier, the spread and assumed correlations cannot be taken for granted, and some dislocations could impact the users of such products. Whether such a situation would continue or not is a question that market developments would answer going forward. However, derivative users should not underestimate the importance of rethinking the hedging framework and exposure, particularly at times where market dynamics are rapidly changing.