LCH SwapClear plans to shift $154 trillion of US interest rate derivatives to a new discount curve on October 17, 2020 – three months after rival CME Clearing intends to make its own switch. The move dampens hopes of an industry-wide ‘big bang’ in which cleared and bilateral markets would transition simultaneously.
The shift will see LCH drop the federal funds rate for calculating interest payments on collateral, also known as price alignment interest (PAI), for US dollar interest rate swaps, and replace it with the new US secured overnight financing rate, or SOFR. LCH will do the same for the discount rate used to calculate the present value of future swap cashflows.
In a July 26 note to clients, seen by Risk.net, the central counterparty (CCP) sets out its provisional transition timetable and proposes a mechanism for neutralising any value transfer from the discounting and PAI switch. The approach combines cash compensation and basis swaps for most users, with a cash-only option for certain buy-side clients.
“Our previous consultation concluded that a single-step process, with compensation, would be the best approach for switching discounting and PAI in dollar products,” says David Horner, head of risk for SwapClear. “Our proposed model now includes cash and swap compensation, with clients having an option to take cash only if they choose.”
CME Clearing is preparing its own switch on July 17, 2020 and is also working on a cash and swap compensation mechanism, according to a July 2019 proposal.
The latest updates present a departure from the co-ordinated changeover envisaged by some swaps users and industry groups, where all clearing houses and even over-the-counter markets would make a synchronised conversion to SOFR for discounting and PAI.
However, CME has not ruled out revising the date for its changeover, to bring it in line with LCH’s planned October move.
“We have received significant support for the one-time switch of discounting and PAI in a manner that is co-ordinated across CCPs and perhaps including the bilateral market as well,” says Agha Mirza, global head of interest rate products at CME. “If there is feedback from the market that supports certain changes in our proposal which helps reach alignment, we would be open to that.”
The scale of the change – LCH recently deemed it the biggest single transformation in the swaps market in three decades – would make it hard for a fully orchestrated effort to meet deadlines set by the Alternative Reference Rates Committee – the working group tasked with cementing SOFR through the US financial markets. Under the ARRC’s ‘paced transition plan’, CCPs must stop accepting new trades with fed funds discounting in the second quarter of 2021.
Although the discounting and PAI switch will not affect the reference rate for swaps, it is crucial for embedding SOFR within the derivatives market and driving liquidity in US Libor’s successor rate as the tarnished benchmark limps towards its post-2021 demise. Dealers normally hedge their discounting liabilities, which would create additional activity in SOFR markets.
For swaps users, a small change in the rate used for discounting and PAI will instantly alter the value of vast swathes of derivatives instruments. CCPs have already found client support for a one-stop change, but now the mechanism to square winners and losers is taking shape.
LCH will apply the switch to all new and legacy US dollar swaps, whether they reference US Libor, fed funds, US consumer prices index or SOFR itself. Mexican peso swaps and non-deliverable swaps in eight emerging markets currencies currently discounted against the fed funds curve, including Korean won and Indian rupees, are also in line for conversion via the proposed mechanism.
“A one-time compensation process covering the complete set of fed funds-discounted products is the most efficient way for us to handle this transition,” Horner says.
CME intends to apply the change only to US dollar-denominated instruments, but according to Mirza, remains “engaged with clients on whether demand and acceptance exist for considering other currencies as well”.
LCH plans to make cash adjustments equal and opposite to any change in the net present value to reverse any immediate impact on conversion. Additional compensating basis swaps, bucketed into key benchmark tenors, aim to mitigate any temporary distortion in the spread between the two discount rates at conversion and hedge future discounting risk. In other words, users will be hedged against moves in the fed funds-SOFR basis after the cash payment date.
While cash compensation alone would be the straightforward method, Horner believes the combined approach is the most effective for restoring the original risk profile and generating a robust conversion price.
“By changing PAI and discounting we are inevitably changing our users’ risk profiles, and cash alone doesn’t compensate for that. But the more serious issue with standalone cash compensation is there’s a big dependency on finding the right market levels to use in the calculations,” Horner says. “The compensating swaps are designed to address both these issues, re-establishing the risk profile you previously had while stabilising the end result against any short-term market disruption around the point of conversion.”
For example, the 10-year spread between fed funds and SOFR may typically trade around three basis points. If this surged to 6bp at the point of conversion before snapping back after the event, cash compensation would adjust for excess gains and losses compared to normalised levels. Basis swaps provide protection against physical delivery of distorted prices as any short-term losses or gains realised in the cash adjustment are offset by valuation changes in the swaps.
LCH also considered swaps-only compensation, but ruled out the approach due to the problem of imperfect replication when trying to represent a portfolio risk profile using a small set of template instruments.
LCH’s proposed compensating swaps are bucketed into six benchmark tenors; two, five, 10, 15, 20 and 30 years, creating the so-called discount risk ladder into which clients will map their positions. An original four- bucket approach created large gaps at the longer end, while a more granular approach offered little improvement in replication accuracy.
“The proposal is designed to maintain the benefits of both approaches while addressing the potential drawbacks,” says LCH in its client letter. “The swaps should provide a buffer against any short-term market distortions, while the cash element should ensure the value compensation is sufficiently accurate.”
Another issue with swaps-only compensation is that some clients are unable to hold such instruments. This may be due to restrictions in their trading mandate or execution guidelines preventing them from entering into a direct swap with LCH. Other users simply don’t hedge their discounting risk and have no mandate to do so, meaning they may be unable to recognise the compensating swaps as risk reducing.
For firms that are unable to book swaps without a fixed leg, compensating swaps can be booked as two outright trades, creating a synthetic version that mimics the economics of the basis instrument.
Those preferring not to use swaps at all can opt out of that element by instructing their clearing brokers. This option is not available to direct clearing members.
As some clients will not take delivery of the swaps, this means the clearing house will not be perfectly flat, leaving residual risk in each maturity bucket. Through a central auction, the CCP will source and price an opposite basis trade for the residual position. The cost of these trades will result in a downwards adjustment in the compensation amount for these cash-only users. An alternative route would be for users to sell their unwanted basis swaps into the open market, but Horner believes the centralised process is more cost effective as it deals with only the residual position.
For example, a client with $450 million notional of longs and $550 million notional of shorts in the 10-year bucket would be subject to an adjustment on just $100 million of offsetting basis swaps across the full $1 billion position.
CME is proposing a similar mechanism with plans to conduct an end-of-day valuation cycle on July 17, moving variation margin and cash payments calculated with fed funds discounting and PAI. On completion, CME would conduct a separate cycle to value positions using SOFR.
The cash and basis swap proposal does not specifically detail any cash-only compensation option, though the exchange is in talks with clients over a mandatory versus optional risk exchange element, with the possibility of an auction cycle for users to unwind risk.
“One way to address the needs of those clients who may not want to exchange fed funds-SOFR basis swaps is to run a side-by-side, opt-in style auction supported by services such as TriOptima and Reset to facilitate unwinding of some, if not all, of the potentially unwanted discounting risk. Clients can also manage the resulting risk themselves,” Mirza says.
For CME, which is already calculating SOFR discount rates for its SOFR swaps clearing service, the same closing mark will be used to price the conversion.
At LCH, which currently offers no SOFR discounting, pricing will be determined by a centralised auction, planned one to two days ahead of conversion date. Clearing house members will be asked to provide live bid and offer prices in each tenor bucket to determine the mid-price for conversion. Details are still being thrashed out with decisions yet to be made on whether non-members can deliver prices into the auction, subject to certain standards.
A crucial sticking point for the discounting switch is how it dovetails with non-cleared trades – in particular swaptions which deliver into cleared interest rate swaps. The valuation of those bilateral instruments is based on the price of the cleared deliverables.
Under the LCH mechanism, any swap cleared by the CCP after the conversion date will be discounted at SOFR whether it is traded directly or results from a swaption. For deeply in-the-money or out-of-the-money instruments due to exercise after October 17, 2020, this could translate into windfall gains or hefty losses unless a similar compensation scheme is developed for bilateral markets.
Swaption users are mulling an industry-wide response to the problem and are looking closely at compensation schemes. The combined cash and swaps approach touted by the two CCPs may not find favour with asset managers trading swaptions as they may be unable to accept the basis trades.
An alternative approach – to offer parallel fed funds discounting for a period of time – has already been ruled out following LCH’s earlier consultation.
“We’re making sure that market participants understand how any LCH-cleared swaps resulting from swaption exercises will interact with this process,” says Horner. “We hope that removing some of the ambiguity around this will help catalyse an industry solution.”
At CME, however, the door remains ajar to a scenario in which the CCP is involved in resolving or addressing the fed fund discounting element specified in swaps underlying legacy swaptions trades.
“We are aware that for other significant players in this process there might be some sort of opposition to that [parallel discounting]. From our perspective if that works for the market and the clients, we will do our best to make it work, but we prefer a solution that is employed across the CCPs and the industry,” Mirza says.
This issue only applies to swaptions traded after 2014 as legacy trades have been carved out of the clearing mandate through no-action relief from the Commodity Futures Trading Commission. This means that on expiry, legacy swaps could be delivered bilaterally instead of to a clearing house.
Editing by Alex Krohn