Benchmark reform poses challenge for valuation teams

The end of Eonia and Libor are set to make life more complicated

After a turbulent decade, the past couple of years have arguably been a little easier for the derivatives valuation community. Overnight indexed swap (OIS) discounting is market standard for cash collateralised instruments, while funding and capital valuation adjustments are no longer a matter of debate. Margin valuation adjustment could be on the horizon, but the Street is largely in ‘wait‑and‑see’ mode.

However, benchmark reform is a potential fly in the ointment. For euro swaps collateralised with cash, the rate used for discounting future cashflows – Eonia – will be banned for use in new trades from 2020, as it will not comply with the European Union’s benchmarks regulation.

Lawyers point out the discount rate is not specified in contracts – it’s up to the parties themselves to choose what rate to use – meaning swap users should be free to use Eonia after 2020. But, as there will be no new Eonia‑referencing swaps traded, no curve can be constructed, making it impossible to continue to use for discounting.

A replacement rate has yet to be selected by the European Central Bank (ECB)-convened working group on euro risk-free rates (RFRs), but sources close to the group believe it’s highly likely to choose the euro short‑term rate (Ester).

The problem is, this rate is under consultation and will not be ready until October 2019, according to the ECB. With Eonia barred from the start of 2020, the market will only have three months to build a functioning Ester curve that can be used not only for discounting, but for OIS trading in general.

The euro RFR working group has already warned that the issue will create potential valuation problems from 2020, and it remains to be seen how the market will deal with this. 

Another problem lies with the potential discontinuation of Libor. In July last year, the UK Financial Conduct Authority said it would give up its powers to compel panel banks to submit quotes to the range of Libor currencies from the end of 2021, which means the rate’s survival will not be certain from that date.

Libor‑based curves are used to obtain estimates for the forward-floating rates, to determine future cashflows. This means there is a risk that Libor forecast curves may no longer be produced in their current form.

If Libor is discontinued after 2021, fallback clauses currently being developed by the industry should kick in, at which point existing contracts linked to the benchmark will reference the alternative risk‑free rate, such as Sonia for the sterling market. A fixed spread will then be added to the rate to take into account bank credit risk. 

The methodology for calculating the spread is still being developed but, when it is, a recent report by Numerix suggests using the fallback methodology to construct an alternative reference rate curve to help get a better view of future cashflows under the new rate. When that curve should kick in is currently anyone’s guess, given some banks are still willing to keep Libor alive beyond 2021.

So, while benchmark reform is starting to impact parts of the derivatives business, it’s unlikely valuations teams will be spared much longer.

Read more articles from the 2018 XVA special Report