IBOR changes: Swaps

The targets of this article are institutions and corporates that use interest rate derivatives (IRD).

In a low rate, low volatility and vanilla single-benchmark environment this still requires careful planning and execution. However, in a more volatile and splintering lending rate environment this introduces new headwinds and dangerous squalls. This is the first of two articles – highlighting the actions being taken by the more global, Tier 1 banks, who are also clearing members of the Central Clearing Counterparties (CCPs). The subsequent article will be from the view of their corporate clients and other counterparties. This article assumes basic knowledge of the  IBOR Transition (see previous posts).

Regulators now require firms to reduce IBOR exposures. This was made clear through coordinated FCA, CFTC and FSB announcements over the last two years;  and more recently through required disclosures from the banks on their IBOR transition progress.  Most recently (26th Feb 2020), the Bank of England announced further initiatives to “turbo-charge” the Sterling LIBOR transition (publishing a daily SONIA Compounded Index, and disincentivising LIBOR-linked collateral by introducing haircuts). The requirement to reduce and transition IBOR exposures is now being reiterated by regional authorities in Asia, beyond solely their domestic currency and lending rates (Taiwan – Feb 25th2020). Although this also affects fixed income cash instruments, this article is concerned primarily with derivative instruments. The required steps banks need to take include – renegotiating their backbook of legacy contracts, preparing for the related CCP changes, and broader investment for operational readiness.

First and foremost, this requires backbook renegotiation and repapering. For swap and other derivative agreements, new terms need to be agreed, and fallback language inserted, to support alternative rates. This exercise began with an exposure discovery and quantification exercise (more on this is available in an earlier post).

Secondly, these banks, as clearing members of the CCPs, will need to prepare for the already scheduled “big bang” changes that will occur in 2020. These changes affect both the method used to value these IRDs (i.e. discounting) as well as the interest that would be paid on any collateral posted (i.e. the price alignment interest/ price alignment amount – PAI/PAA). To quote the CME (Chicago Mercantile Exchange) who along with LCH (London Clearing House) clear USD IRDs: “migrating the discounting and price alignment environment for cleared USD interest rate swap products (IRS) from the daily effective federal funds rate (EFFR) to the secured overnight financing rate (SOFR), in accordance with the ARRC Paced Transition Plan, will foster liquidity across the SOFR term structure. By conducting a single-day transition, we intend to efficiently transition discounting and price alignment while mitigating any potential risks and ensuing valuation changes.”  This is currently scheduled for the 16th October 2020.  Somewhat similarly, for Euro IRDs, Eurex (& LCH) will perform the switch earlier, on 22nd June 2020 from an EONIA-based PAI/PAA and discounting regime, to ESTR (which has already started being published as a rate, since October 2019).

Thirdly and finally, alongside the bank changes needed for these CCP switchovers, are further changes required by banks for their broader technical and operational readiness.  They will be supporting different products, cleared and non-cleared, standardised and bespoke, valued differently using different rates & curves, with interest on collateral calculated differently. Legacy and new will be supported in parallel, with systems and processes expected to manage this seamlessly. This impacts the entire contract lifecycle from pricing, trading, booking, margin and collateral exchange, not to mention risk management, hedge accounting, finance and tax. 

In conclusion, Interest Rate Derivatives including cleared swaps are changing significantly – driven by the regulatory imperative to reduce IBOR exposures ahead of the December 2021 deadline. This affects banks who are also clearing members, as well as their corporate client and other counterparties. This post has examined the impact on banks themselves. Firstly, they’ve gone through exposure discovery and started contract renegotiation, and are now preparing for this year’s CCP switchovers.  All of this is couched in their broader technical and operational readiness – which is exponentially more difficult to support, when an industry and set of benchmarks are already in different states of transition.  In the second article, the perspective of their corporate clients and other counterparties will be examined.

More information on the IBOR Transition and IBOR Readiness Strategies is available upon request.

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