For such a significant change in derivatives market practice, it is remarkable how little interest has been shown in plans to move swaps contracts away from Libor and its foreign-currency counterparts.
The process was kicked off by the Financial Stability Board in 2013, and will come to a head this year. Currency-specific working groups have whittled down the options for their respective new risk-free rates (RFR) to either an overnight rate that complies with new benchmark principles, or completely new secured lending rates.
But how to make the switch? The most aggressive – but also the quickest – option would be to discontinue the old rates, forcing derivatives users to adopt new reference and discount rates for their existing trades. This is a big deal.
Some warn of huge disputes, as counterparties try to agree on new valuations for legacy portfolios, in a process reminiscent of the move from Libor to overnight indexed swap (OIS) discounting after 2008: "How do you agree to the exit value of that trade with your counterparty, and the value of the new trade? You open yourself up to a huge amount of valuation disputes," says one buy-side trader.
Others worry it could threaten hedge accounting relationships, as the new swap might no longer economically match the Libor-linked instrument it's supposed to be hedging. Pension funds and insurers often use Libor-linked curves to discount their liabilities, so moving their swaps off Libor could create mismatches.
There are countless other ways that derivatives end-users in particular could be affected, but reaction so far has been muted. When the subject is broached, even senior buy-side traders initially shrug, assuming it will only apply for new trades. When it's explained that legacy trades may be in scope, the reaction swiftly changes to incredulity.
It is certainly not the fault of the working groups trying to implement this process. Groups in the US, UK, Switzerland and others regularly publish relatively clear and detailed minutes of their meetings online. Regulators have also been clear about their intentions. And while there are no buy-side members of the working groups, there has been outreach to some end-users to gauge their opinions. But still, there appears to be a lack of wider interest in the process.
Of course, the migration may happen smoothly. The UK and US groups are leaning towards a two-stage process. First, they will move existing OIS rates onto the new RFR. Once liquidity is sufficient, they will look to migrate Libor reference rates across.
In a perfect world, a new RFR would be similar enough to the existing OIS rate that re-papering won't be required. Early studies, though, have shown the reformed, transaction-based versions of current rates can differ materially – which may allow counterparties on the losing side of a valuation change to claim the contract is legally void. And as we saw in the debates about termination rights, the buy side would fight hard over any contractual changes.
Market participants may also be so enamoured by the new rate that they move voluntarily. But liquidity may take years to build up, and then it will be split between the new and old rates for some time.
So, as with the termination rights issue, the market might need a push. Working group minutes show OIS transition is likely to take the form of a "big bang", potentially involving an International Swaps and Derivatives Association protocol to allow for mass re-papering of existing contracts.
Then, once the OIS market has moved, the hope is that counterparties will see the light and voluntarily use the RFR instead of Libor as the swap reference rate. Many see the benefits of having swap discounting and reference rates aligned, so this approach may work.
If not, though, the big-bang approach may also be applied to the Libor transition, forcing existing floating-rate references to be changed to a new RFR overnight - a much scarier prospect than a forced change to the discount rate.
With so much at stake, market participants of all stripes should really be going through those working group minutes with a fine-toothed comb.