Sometimes, even seemingly small technical changes can have surprisingly large effects. Exhibit A: This fall, central counterparties (CCPs) will change the way they calculate payments associated with the interest rate derivatives they clear. Specifically, for the past decade, they’ve used the Effective Federal Funds Rate (EFFR) when calculating price alignment interest (the interest paid on variation margin) and discounting of future cash flows for USD cleared interest rate derivatives. Instead, as of mid-October 2020, they'll use the Secured Overnight Financing Rate (SOFR).
The CCP discounting rate change is expected to promote liquidity in SOFR and, ultimately, to support the swap market’s transition from USD LIBOR to SOFR. The largest CCPs, CME Group and LCH Group, have published transition plans designed to neutralize any value transfer from the EFFR-to-SOFR discounting rate change. However, it is an operationally complex process, and swaps that cover trillions of dollars worth of notional will be affected. Banks, asset and wealth managers, and other financial institutions should make plans to prepare for this transition.
If you have exposure to USD cleared swaps, it’s likely that you have already made some key choices related to the transition. CCPs plan to compensate market participants who see the value of their portfolios decline as a result of the methodology change, and they’ve asked companies to choose how they would like to be made whole. Now that you have made your elections, it’s time to prepare for what comes next.
The transition from EFFR to SOFR will be important for building up liquidity in SOFR to support its role as the replacement for LIBOR. SOFR futures have already been growing in daily volume, and the CCP discounting rate change could lead to more liquidity across a range of SOFR swap transactions.
The two major CCPs are largely aligned in their approach to the switch, but there are some nuances between the two that offer different choices, opportunities and risks. The timing is coordinated, so market participants will have to navigate both methodologies simultaneously. Market participants will want to be prepared for what’s similar, and what’s different, between the two.
The CME plans to start the compensation process by preparing a discounting transition report, which it will present Friday, October 16 to investors who hold certain cleared US Dollar interest rate swap products (interest rate swaps, overnight index swaps, forward rate agreements, basis and zero coupon swaps, and swaptions). The report will show what the relevant contracts will now be worth, with their net present value (NPV) discounted on the basis of SOFR rather than Fed Funds swap rates. Because some contracts will increase in value and others will decrease, the report will also state the cash adjustments that the CME will provide to compensate for the change to keep the transition value-neutral. The CME will compute these adjustments based on the end-of-day SOFR curve.
The CME will then post a mandatory series of EFFR/SOFR basis swaps to participants’ accounts. These swaps are intended to restore all participants back to their original discounting risk profile at the portfolio level. However, this move could leave some investors holding new positions that they may not wish to hold — or may not even be permitted to hold, under their investment mandates. For those who wish to unwind these swaps, the CME will facilitate an auction on Monday, October 19.
The LCH will apply cash and swap compensation to all accounts with open SwapClear USD-discounted positions on October 16, including CPI zero coupon inflation swaps, Mexican peso (MXN) swaps and non-deliverable swaps in eight other currencies (KRW, CNY, INR, BRL, COP, CLP, THB, TWD). That same day, the LCH will hold two auctions: one to close out unwanted compensation swaps, the other to provide a reference to calculate the cash compensation.
Besides the nature and timing of the auctions, and the method of calculating cash compensation, the LCH’s approach also differs from the CME’s in that participants may choose cash-only compensation at the start. They will not be required to receive potentially unwanted basis swaps with an option to sell them later at auction or on the market.
Whether you’re a large bank or asset manager for whom USD cleared swaps are a major source of trading and client revenue, or a regional bank for whom such swaps are a relatively small business, this transition poses concrete challenges that could have major economic and strategic consequences. From accounting to client management, new hedging vehicles and longer-term investment opportunities, you need to be prepared.
The big bang could catch back offices unprepared, leading to costly operational incidents and regulatory issues. You should consider confronting these risks with a unified approach, designed to cover all your trading desks. Here are some issues to consider:
The CCPs different methods for calculating basis swaps and cash compensation, and the different auctions for each, ask investors to make elections about how to receive any compensation that may be due to them. By now, you will likely have made those choices. This is tied to a strategic decision: if you use this moment to move to SOFR discounting, you may be willing to auction off the swaps you have received. But if you use the swaps you have received to hedge back to EFFR discounting, you may want to hedge future positions with EFFR-SOFR basis swaps, or exit the hedges over time. (Some market participants may also need to advise their clients on how to view their choices.)
The transition could stress a variety of your systems. At the very least, you’ll want to update risk and reporting systems to reflect the different approach to valuation and how that affects your exposure. You may need to change documentation, procedures, set up new products, and more. Downstream, your back office should prepare to handle settlements, P&L, hedge accounting, VaR models, confirmation messages, data feeds, market platform connectivities, and initial margin / value margin reconciliation under SOFR. Of course, you’ll want to test your new operational measures too — and because of COVID-19, this testing will likely be done virtually.
Some firms may aggregate their offsetting trades internally into a netting, or “wash” account before presenting the combined position to the open market. If you use such a netting approach, you’ll want to be sure your systems will be able to calculate these positions properly.
You’ll want to have a clear approach to capture and book the basis swaps and/or cash compensation that you may receive through this transition. How to address the associated hedging and accounting impacts for these swaps remains a focus for many firms.
Many financial institutions have EFFR-indexed swaps on their balance sheets. Your firm could face volatility if it does not fully anticipate the implications of the CCP discounting rate change. Here are some considerations as you consider the potential market effects of the EFFR-SOFR switch:
While CCPs have developed a discounting rate change process to keep positions value neutral on the day of the transition, they obviously have no control over the EFFR and SOFR basis swap market valuations once trading resumes. Given the large liquidity move from EFFR to SOFR and the auction of, potentially, a large book of unwanted EFFR-SOFR positions, it is possible that investors and market-makers holding EFFR swaps could face near-term volatility in their portfolios after the CCP discounting rate change. Investors and market-makers will want to analyze different scenarios and plan accordingly to avoid any costly mistakes afterwards.
After the transition, swaptions that result in a cleared swap will go straight into SOFR as the discounting rate, potentially affecting their value. Most swaptions, though, are traded over-the-counter (OTC). ARRC recently published its guidance on how to address swaptions, though these are only voluntary. In broad terms, ARRC encourages market participants to specify SOFR as the discount rate, and exchange compensation to offset any value change between EFFR and SOFR discounting. If parties can’t agree on compensation, ARRC recommends that they at least redefine the new “Agreed Discount Rate.”
By now, it’s likely that you will have educated your clients to prepare them for the potential volatility in EFFR-SOFR basis swaps and any other cleared or OTC EFFR swaps they may be holding. Some may need additional hand-holding to explain the transition and the potential after-effects.
In early 2020, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2020-04, providing optional, temporary relief to alleviate the potentially burdensome impacts that could come from modifying contracts or hedging relationships because of the LIBOR transition. Given this treatment, we are not expecting many big strategic shifts by firms. Still, as noted above, you’ll want to be consistent in your approach to EFFR-SOFR basis swaps. In addition, remember that the accounting relief only applies to transition-specific contract changes. If you decide to make other changes to your contracts, hedge accounting could be nullified.
After the big bang, the SOFR market could boom, with liquidity that could quickly extend out to 30 years. This has not happened in the wake of a similar transition from EONIA to €STR earlier this year — or, at least, not yet — so it remains to be seen if it will have a catalytic effect with SOFR. (Of course, the EFFR and SOFR curves have different term structures, which is why the CCP switch is significantly more complex than its predecessor.) You’ll want to consider developing new SOFR products and strategies to take advantage of what could be a promising, all-new market.
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US Deals, Strategy & Operations Leader for Tax Reporting & Strategy, PwC US
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Asset & Wealth Management, Partner, PwC US
Financial Services, Partner, PwC US
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