A forum of industry leaders, including the sponsors of this report, discusses key industry concerns around the transition away from Libor, including how the discontinuation deadline will be impacted by the Covid‑19 pandemic, the benefits and challenges of pre-cessation triggers, and how firms are preparing for ‘big bang’ discounting switches
- Benjamin Bullock, Interest Rate Derivatives Product Manager, Bloomberg
- Chris Dias, Principal, Global Libor Solution Co-Lead, KPMG
- Chris Long, Principal,Global Libor Solution Co-Lead, KPMG
- Alexandre Bon, Group Co-head of Libor and Benchmark Reform, and Head of Marketing and Strategy, Asia‑Pacific, Murex
- Vikash Rughani, Business Manager, triReduce and triBalance
- Angus Graham, Libor Migration Lead, UBS Group
- Dr Robert de Roeck, Independent consultant
Considering the impact of the Covid‑19 pandemic, how realistic is the end‑2021 deadline for Libor’s discontinuation?
Vikash Rughani, TriOptima: I can’t predict how the market will evolve, but our services provide solutions for any outcome. TriOptima has worked to build its compression service so it stands ready and in prime position to help market participants mitigate any uncertainty surrounding their over-the-counter (OTC) ICE Libor swap books.
Angus Graham, UBS: The major firms will be ready. They have the resources to adapt quickly as final market and product details unfold in the coming months. However, this isn’t a ‘first past the post’ challenge – we need to see all financial market participants transition, and that remains extremely challenging. Covid‑19 has taken precious time and resources away from the transition, so those market participants who were previously behind now have a mountain to climb.
The progress also varies by currency, with the US dollar having the largest remaining challenge ahead, given its sheer size and the number of products impacted. The market also needs a solution for the ‘tough legacy’ positions, with no current resolution path to transition and may, for example, need legislative support to be completed.
Benjamin Bullock, Bloomberg: The UK Financial Conduct Authority (FCA) and the Bank of England (BoE) have been clear that their central assumption that firms will not be able to rely on Libor being published after the end of 2021 remains.
Many firms were progressing well with their Libor transition plans prior to the pandemic, and we see evidence that some firms have accelerated their preparation over the past few weeks.
The relaxation of timelines around some of the intermediate steps by the FCA, BoE and the Alternative Reference Rates Committee (ARRC) is sensible and proportionate, and should allow firms more flexibility to focus near-term resources on management of Covid-19, while keeping the end-2021 deadline achievable.
Chris Dias, KPMG: Covid‑19 is having a noticeable impact on the timing and release of financial regulation. Regulatory agencies worldwide have postponed a number of rules and regulations, recognising the added burden Covid‑19 has placed on institutions.
The relief has been carefully measured, balancing the support of markets and the overall economy while continuing to maintain regulatory responsibilities. For example, the Basel Committee on Banking Supervision deferred the implementation of Basel III capital rules by a year, the European Securities and Markets Authority delayed phase one of the Securities Financing Transactions Regulation, and the US federal banking agencies – the Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency – issued a joint statement allowing banking organisations to mitigate the effects of the credit loss standard in their regulatory capital for up to two years.
The same cannot be said for the Libor transition. Global regulators and risk-free rate (RFR) working groups have made it clear that the cessation of Libor by the end of 2021 is a global imperative. Although seemingly resolute on the Libor end-date, regulators seem willing to make some accommodation because of Covid‑19. To that end, certain milestone dates may be deferred. A case in point is the recent Working Group on Sterling Risk-Free Reference Rates announcement to delay the stoppage of all new sterling Libor-linked loans to the end of the first quarter of 2021 due to pressures caused by Covid‑19. In a related example of regulatory willingness to modify efforts to wean market participants off of the ‘Libor drug’, the Fed changed its Main Street Lending Program requirements from the secured overnight financing rate (SOFR) to Libor to ensure access to much-needed financial relief. It appears regulators will bend when rewired to help mitigate risks from Covid‑19. It also appears the Libor transition will continue along a defined path with only minor detours along the way.
Robert de Roeck: At the highest level, the success of the Libor discontinuation project boils down to two key factors: market awareness of the requirements, and the available resource to address those requirements. It is clear the effects of a global lockdown have negatively impacted both elements. To the exclusion of almost all other demands, firms will now be centrally focused on surviving the economic effects of Covid‑19, while simultaneously dealing with lower resource bandwidth because of lockdown. However, given the political imperative to implement these changes, I believe there will be little, if any, rhetoric indicating a softening stance. Despite the additional challenges posed by recent events, I do not think it prudent at this point to assume the current 2021 deadline will be relaxed.
Alexandre Bon, Murex: There is no obvious sign that the end‑2021 deadline for Libor panel bank submission should be impacted by Covid‑19. The official sector is vocally reaffirming that Libor may not exist past 2021, and the UK’s FCA has reiterated it has no intention to revisit the deal struck with panel banks to compel contributions. However, major dealers might keep the benchmarks afloat through voluntary contributions for a while – especially if this is in their interest.
The Covid‑19 situation has also negatively impacted some preparation work. Some interim milestones were pushed, such as the euro short-term rate (€STR) discounting switch or the deadline for issuing GBP Libor-denominated loans, adoption in the cash markets is now behind schedule – which is why national emergency loan programmes are still relying on Libor – and many banks’ client outreach efforts have slowed down during the turmoil.
Certainly, the RFR working groups are closely monitoring the situation, and some relief may be granted if it appears the market cannot meet the deadline. This does not seem justified yet, so I would not expect any official statement to that effect before next year.
Finally, one possible scenario is that not all Libor publications cease on the same date – GBP Libor could be discontinued before USD Libor, for example – which could bring some relief but also new challenges. It is still too early to tell.
The UK’s FCA has extended the deadline for participants to cease issuance of cash products linked to Libor to the end of the first quarter of 2021 – what additional preparation is needed to ensure Libor cash products are no longer issued?
Chris Long, KPMG: The FCA’s extension responded to Covid-19 by giving participants more time to stop issuing Libor cash products.. Whatever the rationale for the extension, it came as a relief to a number of institutions that may have been ill-prepared to meet the Q3 2020 deadline. While efforts to cease the issuance of Libor cash products should have been well under way, the extension provides an opportunity to revisit and possibly reformulate plans to fully transition from Libor to the sterling overnight index average. Firms should look at existing plans to ensure strategy, technology, customer outreach, operations, business process and communications have all been adjusted to reflect the upcoming change. Additionally, should customers continue to require Libor-linked loans, the respite should be used to ensure fallback language is appropriate.
Alexandre Bon: An official RFR forward-looking term rate publication will, once again, make it possible to offer products with an upfront fixing structure. This can ease RFR adoption by corporate small and medium-sized enterprises, so the earlier the better.
Second, we should stop looking at the transition in cash and derivatives markets as two distinct issues. Cash product issuances require liquid swap and derivatives markets to offer adequate hedging solutions. Both segments feed each other, so it is essential to encourage consistency and develop market conventions at a similar pace. So far, divergence between both markets has compounded complexity and created some confusion – one example is whether RFR term rates can be used in fallback language or in new product issuances. Banks cannot yet offer black-and-white answers to their customers, which slows adoption.
Benjamin Bullock: To become reality, end-users of these cash products need to shift their current thought process and show more willingness to invest and borrow in cash products referencing RFRs. For this to happen, consumers and issuers need to ensure their systems and risk management processes can support RFR-based cash products, and the differing conventions and methodologies versus legacy Libor alternatives. The US and the UK have seen good progress with the issuance of floating-rate notes, loans and revolving credit facilities linked to RFRs. However, other jurisdictions are lagging somewhat, likely due to liquidity concerns. Generally, more work is needed across all parties to encourage the use
Angus Graham: The move from Libor requires confidence and liquid markets in the alternative reference rates – which is less a concern for sterling but pertinent to the other currencies – as well as fully featured products.
The term-rate structure is one of the most important features of a cash product, so many market participants will delay transition decisions until clarity is available. This will likely stall the cash market transition or push it to the very end of the timeline.
Considering the discrepancies between the two benchmarks in March, what can we learn about the suitability of the SOFR as a viable fallback for US dollar Libor contracts?
Robert de Roeck: I think one can question the choice and suitability of RFRs on an outright basis – during times of market stress or otherwise. However, it is important to recognise that we are currently in a multiyear transition period, during which time there will exist simultaneously two ‘primary’ benchmark curves. This necessarily gives rise to a basis and, as with all bases, one can expect higher volatility during times of market stress, irrespective of the SOFR choice. During the transition, market participants’ exposure to this basis may present significant economic risks and should factor centrally in the planning and timing of their transition to the new RFRs. Post-transition, the market will hopefully resume to a steady state of one primary curve.
Benjamin Bullock: A long-standing theme during this transition process has been the credit and liquidity spread component within Libor that the market has historically relied on. The International Swaps and Derivatives Association (Isda) fallback methodology, which includes a five-year lookback calibration of the historical spread between the compounded RFR and interbank offered rate (Ibor) fixing, helps minimise the value transfer impact on legacy derivatives/securities upon fallback trigger. Therefore, the widening of the historical spread during periods of market volatility will affect the five-year lookback historical spread calibration. Furthermore, market participants with exposure to credit and liquidity risk may seek to manage this risk with new products.
Alexandre Bon: Both SOFR and Libor behaved largely as expected, the spread widening was a rather logical outcome, and the jump far less pronounced than in the financial crisis that began in 2007–08. Not surprisingly, the SOFR proponents saw confirmation that Libor was a flawed index and SOFR a better alternative, while to some SOFR sceptics this highlighted what they perceived to be issues with the new rate. The debate around whether SOFR is the most adequate fallback option rages on, though – in practice – transition work is progressing on this assumption.
More interestingly, the sudden widening of the Libor-SOFR spread seems to have raised awareness about the inherent risk of value transfers within Isda’s fallbacks. For instance, we have recently seen clients accelerate the work on alternative transition plans for portfolios they were initially thinking of managing through default fallbacks.
Angus Graham: Risk-free (such as SOFR) and credit-adjusted (such as Libor) benchmarks are fundamentally different, so their suitability will depend on application (what risk are you reflecting) and position (whether you’re paying or receiving).
The Covid‑19 pandemic has highlighted these inherent and fundamental differences as the two benchmarks separated due to economic uncertainty, increasing the credit risk premia at levels greater than central banks can offset by interest rate cuts.
For credit risk-free products, a risk-free benchmark is the natural and rational option. However, for products with embedded credit risk, referencing a risk-free benchmark with a static spread adjustment for the credit element passes the credit risk to the floating-rate receiver – which is going to drive very different pricing and countercyclical behaviour from lenders, who need to manage their own funding and liquidity during times of crisis.
The challenge for the market is therefore to build a new paradigm that delivers for clients in the short term, provides them with stability and confidence in the long term – good and bad times – and still treats all participants, including intermediaries, fairly.
Chris Dias: Regulators and the ARRC have made it clear that differences exist between SOFR and Libor. These differences are both structural and behavioural, leading to outcomes that may not align with certain expectations while also bringing about challenges to suitability. There is no doubt that these differences will impact both revenue and profitability, requiring institutions to rethink balance sheet management, credit risk management, interest rate risk and pricing strategies. While, on the surface, the choice of SOFR may not appear a suitable alternative to Libor, it can be made to be a more robust alternative by recognising the differences and making the necessary adjustments.
What role will alternative, credit-sensitive benchmarks, such as Ameribor and the ICE Bank Yield Index, play in transition, and will multiple versions prevail?
Benjamin Bullock: We have recently seen both the US Federal Reserve and the ARRC endorse the potential use of International Organization of Securities Commissions (Iosco)-compliant benchmarks other than SOFR. The post-Libor world will very likely include one of multiple Iosco-compliant benchmarks. A one-size-fits-all approach was unlikely to become a reality, but it is still possible the vast majority of cash and derivatives volumes will migrate to SOFR, which is a perfectly suitable reference index for a range of use cases.
Alexandre Bon: Until now, most of the work has focused on SOFR. However, we have seen some interest in credit-sensitive benchmarks – Ameribor in the US domestic market, for example. Ultimately, the $350 trillion question is whether the market prefers to use several kinds of benchmarks depending on activities and market segments, or whether the benefits of using a single common rate outweighs the view of some that SOFR is less adapted to their needs. The jury is still out.
Angus Graham: Products with credit risk need mechanisms to reflect the risk in pricing – for example, asset-liability management and financial intermediation activity.
A static reflection of that risk – compared with the floating component in Libor – drives very different behaviours, particularly around pricing (to reflect the potential future funding and liquidity risks) and optionality (such as unilateral and bilateral recalls and drawdowns of funding).
It shouldn’t be forgetten that the original market vision was for an evolution to a market design that saw Libor remaining, but in a more robust framework, and a new ‘alternative’ RFR being made available to reduce market dependency and reliance on Libor. The euro and yen market solutions have these features, but the dollar, sterling and Swiss franc do not.
Robert de Roeck: There will always be demand from the different industry demographics for sector- or instrument-specific benchmarks, and they will continue to evolve and play an important role into the future. However, almost without exception, market-makers that provide liquidity in these benchmarks will price and risk-manage them off a primary curve – historically, one of the Ibors.
Although the optics and nomenclature may change, the underlying pricing and risk management will continue to be performed off a primary curve into the future – one of the new RFRs. Benchmarks such as Ameribor will continue to serve an important role but, currently, I do not see them as alternatives or competitors to the new RFR.
Chris Dias: The emergence of credit-sensitive rates indicates the need of some market participants for a rate closer in construct to the current Libor. While these credit-sensitive rates offer some similarities, they are not identical to Libor or have similar issues that made Libor problematic. The need for credit-sensitive benchmarks is predicated on funding and lending costs generally either widening or remaining static in times of stress. The current perception is that, without the credit-sensitive component, banks could experience negative impacts to revenue and profitability from the narrowing between funding and lending, certainly an unwelcome outcome for banks but perhaps not for the real economy. Support for SOFR alternatives would need to address the operational inefficiencies, structural differences between a rate and Libor, and potential accounting problems – currently this is not the case. Additionally, for any UK or European Union‑based financial institutions, any credit-sensitive benchmark would need to be compliant with the EU Benchmark Regulation before it can be used. Alternatively, banks could make adjustments to pricing strategies, increase fee-based lending or employ a more dynamic risk-based approach; in any case, market fragmentation is not the answer.
Industry opinion appears to be moving in favour of pre‑cessation triggers – what are the challenges and benefits of this approach, particularly in light of current market uncertainty?
Alexandre Bon: A first unknown is the duration of the ‘zombie Libor’ period between the publication of a non-representative Libor and final cessation. It could be weeks or months. A fast phase-out minimises discrepancies between contracts transitioning at pre-cessation and cessation points, as well as the risks of manipulation. However, too short a period may not allow effective dealing with products that are difficult to transition, which seems to have been the FCA’s initial concern.
Even with consensus in favour of pre-cessation triggers, we should expect a sizeable portion of the market to prefer cessation triggers – at least for some parts of their portfolios – which could jeopardise the wide adoption of the upcoming Isda protocol. If the sentiment is that permanent cessation might only occur months after the pre-cessation trigger, we may see even more institutions exploring alternative transition strategies and custom fallback arrangements.
Benjamin Bullock: The Financial Stability Board requested that Isda include pre-cessation triggers alongside the permanent cessation triggers in its fallbacks for Ibor derivatives. Following industry consultation, Isda preliminarily decided to incorporate these pre-cessation triggers.
In the event that an Ibor is determined to be non-representative by the FCA, the pre-cessation triggers would allow firms to fall back to the new robust benchmarks rather than remain on a non-representative Libor rate. Market participants have indicated they will not want to continue referencing Libor in existing or new derivatives contracts following a statement from the FCA that Libor is no longer representative. The pre-cessation triggers therefore eliminate the uncertainty surrounding the use of a non-representative index.
The use of pre-cessation triggers in uncleared contracts would align with the cleared market. LCH and CME – central clearing counterparties (CCPs) that clear interest rate swaps – have both stated publicly that they intend to adopt pre-cessation triggers.
Similarly, in the cash market, the ARRC included pre-cessation triggers for cash products referencing USD Libor.
Finally, incorporating pre-cessation triggers and permanent cessation triggers into one protocol would simplify the Libor transition process for many market participants and encourage uptake.
Robert de Roeck: One of the principal objectives of benchmark reform is to ensure the benchmark is produced in a reliable, robust and transparent way. No-one wants economic exposure to a benchmark that is no longer representative of the underlying market so, ostensibly, pre-cessation triggers are a good thing. However, the challenges arise when one drills down into how they might be implemented. The biggest risks arise if different markets, venues or geographies move asynchronously. Imagine a hedging programme where a large part of the derivatives book has been triggered (OTC), while the remainder has not (cleared). Compound that with funded instruments like floating rate notes – that may or may not be triggered – then cross-currency hedging that may have been triggered on one side but not the other. From this perspective, the challenges become clear.
Chris Long: The movement towards pre-cessation triggers is motivated by the market’s need to address the problem created when the regulator deems a benchmark rate to be non-representative without an appropriate fallback in place. Without a pre-cessation trigger, market participants would need to immediately address the ‘non-representativeness’ determination and move their existing exposure to a new reference rate. The selection of a new rate would need to be amenable to all parties of the contract, and be compliant with benchmark standards or regulatory requirements for benchmark use. Having a pre-cessation trigger linked to fallback language certainly alleviates some of these issues. The inclusion of pre-cessation language in all contract types will also avoid the problem if linked contracts don’t fall back in lock-step, introducing basis risk, hedge accounting issues and operational nightmares. The inclusion of pre-cessation language certainly has a number of advantages, but is not without its challenges. The determination of non-representativeness does not necessarily mean permanent cessation, which implies Libor can be published for a period of time following the ‘non-representativeness’ trigger. This will add confusion to market participants unprepared for the change.
Angus Graham: The overarching design principle is consistency across products – either all or none. The industry operates by hedging across markets, products, currencies, and so on, for economic reasons and accounting/regulatory drivers. A situation where fallback triggers create either a basis risk in economic hedging or dissolution of accounting netting sets would mean a negative profit-and-loss (P&L) impact and, fundamentally, a much less efficient market design.
What steps should firms take to prepare for Libor transition and how are firms coping with the operational challenges involved?
Benjamin Bullock: The majority of firms have already made great progress with their Libor transitions, and should continue moving forward with their already established road maps. The end-2021 deadline remains, and the interim milestones have been clearly detailed by the FCA, BoE and ARRC. For firms that have not yet focused resources on Libor transition, establishing a road map should be a priority. There is a wealth of information available from the official and private sectors to help firms start engaging with vendors, customers and counterparties to create clear road maps to transitioning away from Libor.
Angus Graham: Libor transition represents a truly seismic shift in market structure, which requires top-of-house commitment that should not be underestimated.
Some of the new features – such as compounding in arrears (replacing forward-term structures) – are major process and IT redesign tasks. In addition, the forensic understanding of contracts, which is essential to ensure a complete and successful outcome, requires a heavy change effort and programme governance structure.
Vikash Rughani: Preparation comes in three steps:
- Determining your exposure to ICE Libor in terms of trade count, risk, mark-to-market and counterparty risk
- Ensuring you are engaged with industry initiatives to continue contractual performance in the event of ICE Libor discontinuation, determine their appropriateness for your trades and act accordingly. This may start by looking at industry-derived fallback language and the associated protocol
- Considering whether the fallbacks or amended contract language satisfies your needs, or how you might proactively manage your exposure as soon as possible so you have greater certainty now, regardless of any potential transition.
Central to determining this exposure is understanding all the various nuances that determine the true exposure to ICE Libor across jurisdictions, counterparties, index periods and across cash and derivatives transactions. Also, you should take account of how actively ICE Libor is traded across the organisation today. Another key part of understanding ICE Libor exposure is the hedge accounting and tax treatment of various trades in a portfolio. A great deal has been made of the vast amount of notional tied to the ICE Libor benchmark but, in practice, much of that notional is sticky, with other implications inhibiting one’s ability to simply remove or convert trades in isolation.
Furthermore, fallbacks will be a vital seatbelt for market participants, but they will not solve all the challenges of uncertainty and risk. Holders of ICE Libor exposure will still be subject to interim market moves and taking snapshots at arbitrary points in time without any control.
If market participants choose to convert some of their ICE Libor swaps portfolio now, they can do so through a combination of termination and risk replacement into the alternative RFR. This can take place through bilateral execution in the market or through services such as triReduce, which allows bulk compression and conversion of ICE Libor exposure at each participant’s own mid-market valuations. By taking this approach, market participants can compress gross notional down to the core net risk position while ICE Libor trading continues, and convert trades to reference the alternative RFR within risk-based limits defined by each firm and based on a common toolkit available to all market participants.
The value comes from not having to cross bid/offer when converting interest rate swaps exposure into the alternative RFR, and doing so in a controlled iterative manner rather than exposing one’s full position to the market. Those firms that can bulk terminate, amend and book replacement trades, or leverage CCP messaging for such transactions without operational constraints, will find themselves best placed for the orderly conversion that will deliver greater certainty for their interest rate swap books.
Alexandre Bon: The first step is reaching out to business partners to understand their views and needs for the transition. Will they sign the Isda protocol? Do they plan to repaper their credit support annexes (CSAs) and negotiate compensation for the discounting switch impact? Do they intend to transition their derivatives books early? Only then would you get a clear picture of all the variations, options, complexities and new business opportunities you should prepare for.
Finally, transition events, such as the discounting switch or transaction fallbacks, bring huge operational complexity and significant challenges for infrastructure and back offices. For example, trades undergoing a fallback will use different fixing conventions than new trades on the corresponding RFR. Firms need to automate the corresponding contracts’ transformation – including specific adjustments for broken periods, treatment of foreign exchange-implied indexes or the application of custom fallback arrangements – and efficiently streamline the corresponding impacts across all business processes: settlements, P&L, hedge accounting, value at risk, confirmation messages, connectivity to market platforms and initial margin/value margin (VM) reconciliation. The impact on systems and processes should not be underestimated and will need to be tested well in advance.
Robert de Roeck: By now, firms should, at the very least, have assessed their economic exposure to Libor across their books of business, as well as where Libor may appear in their corporate documentation. Given that different geographies and different instruments are moving on different timescales, I would expect most executive boards to have been briefed and have in place a high-level plan specifying where resources should be prioritised to address specific exposures as the faster-moving markets evolve. Recognising the nascent state of many of the new RFR markets, compounded with issues around the Covid-19 lockdown, the board should be making conscious and informed decisions around acceptable levels of risk the firm is able to weather in a resource-constrained environment. I might also suggest that now, more than ever, is a time to feed back through industry bodies to the relevant RFR working groups to highlight the need for clarity and support as the market evolves.
Chris Dias: A number of operational factors must be considered as organisations prepare to transition away from Libor. Continued uncertainties in the market coupled with the breadth of the impact require firms to be agile and plan effectively to be operationally ready for new RFRs. Firms should consider changes and updates required to processes, systems and models to be operationally ready to book new products in the RFRs in alignment with market and industry timelines. The steps firms should consider include:
- Establishing a new product strategy and implementation working group to drive operational planning and implementation efforts
- Defining business strategies and timelines for reducing reliance on Libor for new product issuance, including the selection of RFR alternatives and offerings
- Ensuring each business line – and core functions such as finance, treasury, inventory technology, operations and modelling tools – understands specifically where they are using Libor
- Defining requirements and implementing capabilities to build SOFR/other new-rate financial products that will replace Libor products
- Co‑ordinating change management for internal systems, models and vendor software releases, changed data interfaces and system replacements for those unable to support the Libor transition
- Building testing plans for new product capabilities, models, model validation and the operationalisation of fallback processing
- Undertaking conduct-readiness assessments for systems changes, data management, operational procedures, final communications, product releases and transition go-live.
How are firms preparing for ‘big bang’ discounting switches, which CCPs plan to run in July and October?
Angus Graham: The big bang itself is operationally manageable and is one of the benefits of having exposures consolidated in the CCPs. The second-order effects are where more effort is needed – for example, the knock-on work required to align bilateral OTC documentation and contracts.
Vikash Rughani: The challenges related to the €STR discounting switch in July and the US dollar SOFR discounting switch in October vary greatly. In the switch between the euro overnight index average and €STR, there is a known fixed spread – 8.5 basis points. For SOFR, the spread between Federal Reserve funds and SOFR is variable, albeit at vastly lower levels based on historical data.
Some ways firms are preparing for this change are by mitigating the impact of the change and preparing for life after the change. The discounting switch is seen in both jurisdictions as a method of increasing adoption – through new hedging and trading activity – of the €STR and SOFR alternative RFRs.
To mitigate the impact of the change, firms are looking at the potential of recouping their existing trades, driving down VM and risk sensitivity to the discounting curve. This may not be an option available to all market participants, depending on their goals – the intention being to reduce the VM and risk change of a switch from one discounting curve to another.
We are speaking with our customers about ways in which we can help reduce the impact of the discounting switch, but the weeks before the discounting switch will be the time any such mitigating actions will need to be taken, either bilaterally or multilaterally.
Following the discounting transitions, each new euro or US dollar interest rate trade – and non‑deliverable currencies in the case of LCH – cleared will be subject to discounting at the new curve. So, inherently, firms used to hedging their risk to discounting will look to hedge that exposure on a periodic basis – in turn adding trading activity to the alternative benchmarks, which will then feed greater efficiency into those markets.
From a triReduce perspective, we compress both €STR and SOFR swaps and see any additional liquidity as new opportunities to compress and deliver greater capital efficiencies for our customers. As a second-order effect, the added liquidity will also help any steps to convert into these alternative RFRs, since the more liquidity there is, the greater ease the market will have in performing the conversion.
The other way firms are preparing is by planning for renegotiating their bilateral CSAs to remove this consequential source of basis risk between cleared and non-cleared exposures. The market has worked at length to implement mechanisms to handle the impact of swaptions exercising and the mandate to clear, but the question of discounting comes up every time bilateral counterparties consider backloading a trade into clearing.
Alexandre Bon: The priority is on anticipating the valuation impacts – P&L, sensitivities, valuation adjustments (collectively known as XVA) – and rebalancing hedges. A good proportion of Murex’s clients have relied on our Libor impact analysis features and its tool for emulating the CCPs’ swap-compensation mechanisms, and I believe most institutions seem well on track on this front. More advanced firms are now working on the thornier issues of the swaptions impacted by the discounting switch and the renegotiation of CSAs to realign collateral rates with the CCPs’ standards.
Robert de Roeck: By now, firms should understand the potential economic impact of the switch and be well advanced on operational readiness to handle the new valuation basis. The former should be performed within a robust risk framework, and choices to retain, minimise or remove exposure should be considered as active risk/reward investment decisions. In particular, attention should be focused on those positions that have the largest discount delta – exposure to the discount curve – as mark-to-market valuation changes here are likely to be observed.
Benjamin Bullock: The major CCPs have communicated their approaches to handling the upcoming discounting changes. Firms need to make sure they have engaged with their CCPs or clearing brokers to fully understand the risk and valuation implications, and importantly their options for dealing with risk transfer as a result of the discounting changes. There may also be short- and long-term discrepancies or lack of harmonisation between conventions of cleared and bilateral derivatives. In addition, dealing with the €STR and SOFR-based risk will be new to some firms, and they should make sure they have access to the relevant market data and analytics to deal with these new RFRs. Where firms are struggling to assess impacts themselves, they can depend on technology vendors such as Bloomberg to help provide data, risk analytics and independent valuation impacts.
The panellists’ responses to our questionnaire are in a personal capacity, and the views expressed herein do not necessarily reflect or represent the views of their employing institutions
The KPMG name and logo are registered trademarks or trademarks of KPMG International. This article represents the views of the author and does not necessarily represent the views or professional advice of KPMG LLP.
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