Traders see easy switch off Libor in Swiss market at year-end

Saron swaps trading still slow but traders say liquidity is rising and see no hurdles to transition

Less than a year before Swiss franc Libor is due to disappear, trading in derivatives referencing its replacement amounts to just a fraction of overall volumes – but Swiss market participants are confident transition off the tarnished benchmark remains on track.

Traders and brokers say a number of hurdles to the switch have now been overcome and point to signs that liquidity in Saron derivatives is starting to grow.

Available data is yet to show a sustained rise in Saron volumes but there is some evidence that the transition is speeding up.

Félix Roudier, head of Swiss franc rates trading at Credit Suisse, says volumes in the Saron derivatives market have picked up since late February and adds: “I think they’ll continue to do so as remaining portfolios get restructured.”

He says a high percentage of the bank’s institutional counterparties trading Swiss franc Libor derivatives have restructured their books and now trade only derivatives that reference Saron.

The trend in the interdealer market is also promising. Jan Harms, head of Swiss derivatives at Gottex Brokers, estimates that roughly a quarter of the firm’s flows in late March was in Saron, up from only around 5% last year.

“It’s just not quite as popular yet for one reason or another, but I’m fully confident it will switch over really easily. We don’t have any problems at all finding liquidity in Saron,” he says.

He thinks liquidity in the interdealer derivatives market will be evenly split between Saron and Swiss franc Libor by June-July and will transition fully to Saron by December 31, after which date all but some US dollar Libor settings will be discontinued. 

Pascal Anderegg, an interest rate derivatives trader at Zürcher Kantonalbank, attributes the still-limited interdealer trading in Saron interest rate derivatives to a habitual preference for Libor swaps, saying there is in fact enough liquidity in the Saron alternatives.

Data from LCH shows that overall Saron volumes are dwarfed by Libor activity. In March, the central counterparty cleared $65.2 billion notional in interest rate derivatives referencing Saron and a fixed leg, compared with $442.9 billion referencing Swiss franc Libor and a fixed leg.

Data compiled by the International Swaps and Derivatives Association and Clarus Financial Technology paints a similar picture. In January and February, monthly trading in Saron interest rate derivatives comprised less than 10% of Swiss franc swaps’ DV01, a key measure of risk that quantifies a swap’s monetary change from a 1-basis point move in rates.

But there are signs in the data that volumes are moving in the right direction. In January, on the DV01 measure, Saron interest rate derivatives began making up a majority of trades where the expiries were more than two years away and they retained this dominance in February. In contrast, last year Saron’s monthly proportion of DV01 for longer-dated derivatives averaged 31% (see chart 1).

 

 

Stefan Pomberger, head of Vontobel’s money and capital market platform cosmofunding, offers an explanation why the long end of the curve is the first to show a move to Saron. He says traders have been focused on longer-dated derivatives because short-dated swaps will roll off their books shortly after the end of the year. If these contracts are not restruck before December 31 to reference Saron, fallbacks are likely to kick in and, soon after, the contracts will have to be restruck anyway when they expire.

Tailwinds

Market participants are optimistic that liquidity in Saron derivatives will continue growing.

“The general opinion within the NWG is that on the derivative side, many critical milestones have been reached,” says Roudier at Credit Suisse, referring to the National Working Group on Swiss Franc Reference Rates, which brings together representatives of the Swiss National Bank and the private sector. Roudier chairs a sub-working group at the NWG that focuses on derivatives and capital markets.  

The spread adjustment that will apply to swaps automatically converted to Saron upon Libor’s death was fixed on March 5, removing what Roudier calls “the last big hurdle to liquidity provision”. On that day, the UK’s Financial Conduct Authority announced that publication of Swiss franc Libor, along with most other Libor benchmarks, would cease immediately after December 31.

For legacy swaps adhering to the Isda fallback protocol, Swiss franc Libor will switch to a compounded version of Saron at the relevant tenor, plus the spread.

For example, for Swiss franc swaps referencing the commonly used three-month fixing, 0.31bp will be added to Saron when the swaps fall back. At the 12-month point, fallen back Swiss franc Libor swaps will receive a 20.48bp adjustment.

Photo: Brett Gamston

LCH will automatically convert outstanding Swiss franc Libor trades on December 4 and 5

The adjustment’s calculation as the median spread over a five-year period meant dealers could be fairly confident recently in the adjustment’s size. But certainty helps, Roudier suggests.

“As a market-maker, even if you know more or less where [the spread will be], you can’t just load one-sided risk into your book and hope you’re not too far off,” he says.

Dealers needed to hedge their Saron-Libor basis, given the risk that Libor transition could be postponed. This risk was highlighted in November, when Libor’s administrator proposed to delay the demise of some US dollar Libor settings.

A second reason for optimism on the transition cited by market participants is a safety net available for cleared trades.

Interdealer Swiss Libor trades are mostly cleared through LCH, and the clearing house will automatically convert Swiss franc Libor trades that are outstanding on December 3 over the weekend of December 4 and 5, applying the spread adjustment to the Saron leg. LCH will charge a fee for the service.

But even well ahead of early December, the prospect of this automatic conversion should encourage trading in Saron rather than Libor, suggests Anderegg at Zürcher Kantonalbank, who warns that participants could end up with some unusual trades after the conversion. Such trades would be harder to offset. Therefore, it makes sense to move onto Saron now rather than continue to trade in Libor, he says.

The derivative markets will follow [cash products] accordingly with hedging activity

Stefan Pomberger, Vontobel

Another tailwind for the Swiss transition is the smaller challenge posed by so-called tough legacy derivatives contracts, compared with sterling and US dollar markets.

According to the Swiss Financial Market Supervisory Authority, or Finma, the volume of tough legacy contracts in the Swiss market is “small and not an existential issue”, states a summary of the NWG’s latest meeting, held on February 1, which was attended by a Finma representative.

At the end of September, only 0.1% of over-the-counter Swiss franc Libor derivatives maturing after 2021 were tough legacy contracts, according to a Finma presentation included in the NWG minutes.

Finma noted that the tough legacy designation for OTC derivatives covers complex trades where the Isda fallbacks cannot be applied; contracts where counterparties are not responsive due to wind-down, incapacity or death; and contracts with multi-party counterparties where consent to necessary changes may not be reached in time.

A small – 8% – share of Swiss Libor floating rate notes maturing after 2021 falls into that last type of potential tough legacy contracts, because for these trades multi-party consent may not be reached by the end of the year. These contracts amount to Sfr60 million ($65 million).

However, even in trades that do not fall under the tough legacy umbrella, it may be difficult for counterparties to sign off on changes in time – partly due to the Covid-19 pandemic, cautions Christopher Cherdel, head of financial management at Banque Cantonale Vaudoise. He cites the example of compliance rules for offshore activities.

“It may not be tough legacy in a legal sense, but in a practical sense, it can turn out to be one,” he says.

For some, these difficulties are outweighed by the factors propelling the Swiss derivatives market towards Saron.

Another accelerator is the rapid adoption of the risk-free rate (RFR) in Swiss cash products such as mortgages, says Vontobel’s Pomberger, who is a member of the NWG. “The derivative markets will follow accordingly with hedging activity,” he says.

I don’t think anybody was expecting that the futures on Saron would be very liquid immediately. I think everyone was focusing on the swaps

Christian Bahr, Six

The recent signs of an accelerating transition to Saron in Swiss derivatives will be welcomed by the NWG. At the February 1 meeting, its members expressed concern over “the slow development of the Saron-based swap market” and reiterated their recommendation to switch to the replacement benchmark ahead of December 31.  

“An early transition would allow to reduce remaining risks (Isda fallbacks are more complex and not perfectly aligned with standard RFR swaps) and is in line with the guidance by Finma to use RFR-based derivatives after June 2021,” the NWG minutes state.

Finma has set a June 30 deadline for supervised institutions to ready their systems for alternative RFRs and, where possible, stop entering into new derivatives contracts referencing Libor.

The Swiss franc futures market appears further away from switching to Saron. Both Eurex and Ice offer three-month Saron futures, but the combined open interest in all available Saron futures contracts totalled only 352 contracts in mid-April, according to Bloomberg data. That compares with more than 231,000 contracts in open interest across all Ice three-month Euro Swiss franc futures, which settle based on the three-month Swiss franc Libor fixing and are commonly used.

Still, market participants are unconcerned. Roudier at Credit Suisse says liquidity in Saron futures should now improve, given the publication on March 22 of transition plans for the main futures contracts, including Saron contracts.

Christian Bahr, head of index services as Six, adds: “I don’t think anybody was expecting that the futures on Saron would be very liquid immediately. I think everyone was focusing on the swaps.”

Editing by Olesya Dmitracova