7 minute read
On the 17 April the LCH1 announced a 5 week delay to 27 July for the move from EONIA2 to €STR3 discounting for cleared trades due to concerns over operational risks created by COVID-19. We expect Eurex and CME4 to follow suit.
The CCPs5, the ECB6 and the members of the clearing houses have been struggling with whether in the light of all the disruption caused by the Coronavirus, it was still right to go ahead with the switch on the previously agreed date of 22 June. The ECB ran a survey of the EU RFR7 working group members to poll opinions, but the results were inconclusive. Notwithstanding this, LCH has decided upon a short delay to 27 July to ensure "a safe transition with the minimum of operational risks".
The balancing act...op risk, swaptions and SOFR8
It is a balancing act between the risk of going sooner (ie June) when so many are still likely to be working from home (and operational, technology and front office staff are stretched) versus delaying, and potentially crowding up against the Fed Funds to SOFR discounting switch in October, creating delivery risk there. In the end a compromise of moving in July was reached, allowing a bit more time for preparation while not getting too close to the US date.
The issue is further clouded by a heated debate around swaptions. Swaptions are generally priced as if they were to settle via cleared swaps, meaning that they will use the discounting curves in use by CCPs at the point they are exercised. If those swaptions were entered into under the expectation of a different discounting curve, then there is a valuation difference and a case for an agreed compensation between the parties.
Since the end of March a new flag 'Agreed Discount Rate' has been added to confirmations, meaning there is now no doubt which discounting curve was used when entering into the swaption. The market convention since then has been to populate with €STR if expiring after 22 June, EONIA if before that.
But that leaves two areas of uncertainty: 1) will there be a compensation mechanism and how will it work?; and 2) assuming yes, what population of trades will it apply to? Since the end of March we can say with certainty that new trades expiring after 22 June are with €STR discounting, though CCP settlement will only match that now from 27 July. And pre September 2019 they were EONIA and some compensation may be due. The debate is around the population in the middle.
The change to the CCP date from June to July adds some further operational complexity, as swaption trades entered since the end of March (using €STR) and expiring before the new switch date, would have a payout that diverges from the price of the underlying cleared swap (as cleared swaps as of this date would still use EONIA discounting). There is a consultation from ECB on the compensation mechanism where closing date was extended to 17 April (the ARRC9 consultation closed on 9 March).
See the timeline below of the key dates linked to the swaption question:
Whatever the pros & cons of the alternatives, the CCPs have now at least made a decision, and gone with a short delay to July.
And that leaves the bi-lateral market...
The assumption has always been that the bi-lateral market would try broadly to follow the timing set by the CCPs for cleared. Ideally you don't want the cleared and non-cleared markets discounting off different curves given one tends to offset the other, though that basis can be managed by trading desks over a short time period.
So with July now the cleared date, expect an uptick in communications from counterparties asking what your plans are for changing CSAs10 to discounting based on €STR flat. That is an operational challenge in its own right that will place further pressures on organisations.
The switch is intended to be economically neutral, with changes in MTM11 valuations caused by the 8.5 bps12 change from EONIA to €STR offset by a compensating fee payment. But that still means agreeing a valuation, amending trades and issuing the payments, which could be quite a challenge between organisations with large bi-lateral portfolios (again with everyone working from home).
SOFR move is the elephant in the room
CME and other CCPs plan to move discounting from Fed Funds to SOFR on 16 October. This is seen as a critical step in building liquidity in SOFR, and therefore the overall transition path for USD LIBOR13 as well (and indeed for the cross currency market). For many October is already late (in terms of USD14 transition), so there would be resistance to moving that date out (not that that has been suggested yet). But the FF15 to SOFR switch is much more complicated than the EONIA to €STR flat one, as both rates are floating, and the compensation mechanism will be more complex.
For more information on the background to the discounting changes see the summary from ISDA16 in their 2020 RFR Major Developments paper (pp 11-13), the detailed LCH transition plans (for SwapClear members and clients only) and the CME pages for €STR and SOFR.
So what do we think?
Well this is a balancing act. We were concerned about the risks in June, but would have been worried about October if June had become September. The move to July buys some time while avoiding that risk (albeit with a minor additional headache for swaptions exercising during those 5 weeks).
Normally market participants would avoid large transition events in the middle of the holiday season, but with COVID upsetting all those plans anyway that is perhaps less of a concern this year.
So far, per recent BoE17 announcement, the LIBOR end-2021 date has not moved so pushing interim milestones too much to the right might lead to some bigger problems down the line.
The reality is that in the current crisis there are no perfect answers and we can't let perfect get in the way of DONE.
Additional contributing author: John Stevenson-Hamilton
- LCH – London Clearing House
- EONIA – Euro Overnight Index Average
- €STR – Euro short-term rate
- CME – Chicago Mercantile Exchange
- CCPs – Central Counterparty Clearing House
- ECB – European Central Bank
- RFR – Risk-Free Rates
- SOFR – Secured Overnight Financing Rate
- ARRC – Alternative Reference Rates Committee
- CSA – Credit Support Annex
- MTM – Mark to Market
- bps – basis points
- LIBOR – London Inter-Bank Offered Rate
- USD – US dollar
- FF – Fed Funds
- ISDA – International Swaps and Derivatives Association
- BoE - Bank of England