LCH won’t back single fix for swaptions switch

Clearing house pledges to “support” multiple solutions to discounting problem

LCH and dragon
LCH headquarters in London

Clearing house LCH will not develop an industry-wide method for compensating swaptions holders when the benchmark for interest rate swaps shifts to new risk-free reference rates next year.

A senior figure at the clearer told a conference on October 31 that he viewed the change as a “bilateral issue” to be thrashed out by swaptions counterparties on a case-by-case basis.

The firm’s position will affect the majority of swaptions holders whose contracts reference swaps cleared at LCH.

“I don’t think there’s a one-size-fits-all approach to this swaptions issue,” said Baskar Ramachandran, Americas head of business risk for rates and FX derivatives at LCH. “We’re more than happy to support the industry by giving them tools – compensation valuation tools. We think there are several solutions and we’re happy to supply those tools, but at this point we see this as a bilateral issue.”

Rival clearer CME released its own proposal for revaluing affected swaptions on October 22.

Clearing houses are set to change the rate used to discount the present value of euro and US dollar interest rate swap cashflows, with €STR and SOFR replacing Eonia and the federal funds rate, respectively. The rate used to determine interest payments on cash collateral for both currencies – so-called price alignment interest – will also change.

CME Group will make the switch to SOFR discounting for US dollar swaps on October 16, 2020, after initially seeing some support for a July date, while LCH has made plans to switch the next day. Meanwhile, Eurex and LCH will likely shift euro swaps to €STR flat on June 22 next year, according to current plans.

Swaptions – which are options on swap contracts – typically are entered into bilaterally but with agreements to centrally clear the underlying swap. Legacy swaptions would have been priced assuming the swap delivers into an Eonia or fed funds discounted swap, but once the discounting and price alignment interest changes are made, the swaptions will deliver into swaps linked to the alternative rates.

Speaking on the same panel, Sean Tully, global head of financial and over-the-counter products at CME, said there is “a lot of concern” about how to solve the swaptions valuation issue and that clients have told him they would like a universal approach to the issue – at odds with LCH’s position.

This could be a problem because LCH clears the vast majority of interest rate swaps, and most swaptions refer or deliver into cleared LCH swaps. CME has published its own ideas of how to solve the swaptions conundrum, which include acting as a calculation agent and helping facilitate the passing of money between two firms. Tully said the release has had positive feedback but that might not be enough.

“We’ve offered [our solution], and a lot of clients have said yes but clients say they’d like a single approach for the whole industry – a uniformed approach across both clearing houses,” he said. “I don’t think LCH are too interested. I don’t know why.”

The Alternative Reference Rates Committee, which is overseeing the transition away from Libor in the US, confirmed in its latest minutes from September that a working group is “examining potential solutions for these issues”.

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