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ISDA Paper Outlines Challenges of RFR Transition

In a new research paper on the transition from LIBOR and other interbank offered rates (IBORs) to alternative risk-free rates (RFRs), ISDA discusses “one of the biggest challenges facing the financial industry”.

ISDA says the shift is critical because of the issues associated with the robustness and viability of some IBORs – and LIBOR in particular – given the sharp decline in activity in the unsecured interbank funding market.

The paper examines several major upcoming developments in 2020 related to the adoption of RFRs, including the publication of new benchmark fallbacks for derivatives contracts and central counterparty (CCP) changes in discounting and price alignment interest (PAI) for certain currencies.

The UK Financial Conduct Authority (FCA) has clearly stated that it will not compel the banks that submit quotes for LIBOR to provide submissions beyond the end of 2021. The future of LIBOR in all five of its currencies is therefore uncertain after that date, notes ISDA. Given the volume of transactions that still reference LIBOR and the less than two years remaining, it is crucial that market participants focus now on transitioning to RFRs and ensuring that any remaining LIBOR contracts have robust fallbacks in place so that they are nor exposed to uncertainty and risk if and when LIBOR ceases, the paper states.

As new swap contracts are expected to incorporate the amended 2006 ISDA Definitions, this will create an incentive for market participants to adopt the new protocol for their legacy portfolios so that they have the same fallbacks in both new and legacy IBOR contracts. However, agreement to amend legacy contracts to include fallbacks (either via the protocol or bilaterally) may depend on having more clarity on the regulatory, accounting and tax implications of the transition. There have been many positive developments in this regard, both in the US and globally, over the past six months. Additionally, the largest CCPs have indicated they will adopt the amended definitions and thereby achieve an equivalent outcome as under the new protocol for their legacy cleared portfolios, notes ISDA.

The CCP discounting and PAI change will be important for further embedding €STR and SOFR within the derivatives market and driving liquidity in €STR and SOFR products, the paper states. For example, as dealers usually hedge their discounting liabilities, the switch to SOFR discounting and PAI is expected to create additional trading in SOFR overnight index swap (OIS), EFFR-SOFR basis swaps and SOFR futures. As CCPs issue compensating/hedging EFFR-SOFR basis swaps with longer maturities as part of the transition to SOFR discounting, the unwind/auction of these swaps by market participants that choose to do so will drive trading activity in these swaps around and beyond transition. It is expected to extend the tenors of SOFR swaps and create liquidity across the entire SOFR curve.

The FCA and the Bank of England published a statement in January 2020 encouraging market makers to change the market convention for sterling interest rate swaps from LIBOR to SONIA on March 2, 2020. This change is intended to move the greater part of new sterling swaps trading to SONIA and reduce the risks from creating new LIBOR exposures, the paper says.

The UK Working Group on Sterling Risk-Free Reference Rates has identified ceasing issuance of sterling LIBOR-based cash products maturing beyond 2021 by the end of the third quarter of 2020 as one of its top priorities. As market participants start issuing more cash products that reference SONIA and other RFRs, it might also increase demand for RFR-based derivatives products.

IBOR Fallbacks

The transition to RFRs is happening across all major currencies, although the process and the progress varies across different jurisdictions, the paper notes. To address the risk that market participants may have continued exposure to IBORs, ISDA is amending the 2006 ISDA Definitions for derivatives contracts that reference IBORs. These amendments will incorporate fallbacks for 11 key IBORs.

There are some fundamental differences between IBORs and RFRs. RFRs are overnight rates, while IBORs are available in multiple tenors. Additionally, IBORs incorporate a bank credit/liquidity risk premium and exhibit different liquidity characteristics and fluctuations in supply and demand compared to RFRs.

Due to the structural differences between IBORs and RFRs, certain adjustments to RFRs are needed to ensure that derivatives contracts referencing IBORs will continue to function as closely as possible to the original agreement if fallbacks referencing the RFRs take effect, ISDA says.

ISDA consultations have established that market participants prefer to use the compounded setting in arrears rate to address differences in tenor between IBORs and overnight RFRs, and the historical median over a five-year lookback period approach to deal with differences in credit/liquidity risk and other factors such as liquidity and fluctuations in supply and demand.

ISDA will also publish a protocol that will enable market participants to include the amended 2006 ISDA Definitions in legacy IBOR contracts if they choose to. Both the amended 2006 ISDA Definitions and the protocol are expected to be finalised in 2020.

While not resulting in any immediate increased exposure to the RFRs, the work will hopefully be a helpful catalyst for dealers and customers in adopting the RFRs and ultimately transitioning legacy LIBOR portfolios to the RFRs, because these fallbacks will result in contingent exposure to the RFRs in the event the fallbacks are triggered and the fallback rates apply, ISDA notes.

Specifically, Bloomberg’s publication of the spread and term adjustments together with contractual agreement to reference those fallback rates may provide clarity to market participants on future valuations of IBOR – and in particular LIBOR – contracts, ISDA says. Market participants might choose to amend their trades to incorporate IBOR fallbacks, close out their IBOR positions and/or reprice their contracts by moving them to RFRs before fallbacks are triggered.

The Alternative Reference Rates Committee (ARRC) Market Structures Working Group identified nine possible models of conversion that market participants may use when voluntarily transitioning derivatives transactions that reference IBORs to RFRs.

As new swap contracts will automatically adopt the amended 2006 ISDA Definitions, it could create an incentive for market participants to adhere to the protocol so that legacy IBOR portfolios have the same fallbacks, says ISDA. However, an agreement to amend legacy contracts to include fallbacks (either via the protocol or bilaterally) may depend on having more clarity on the regulatory, accounting and tax implications of the transition. There have been many positive developments in this regard, both in the US and globally, over the past six months, the paper states.

CCP Shift to PAI and Discounting

CCPs, including CME Clearing, LCH SwapClear and Eurex Clearing, are planning to update the PAI/PAA and discounting on all cleared euro-denominated products from EONIA to €STR flat (no spread). The switch is expected to take place in June 2020.

CME Clearing and LCH SwapClear are planning to change the discounting and PAI/PAA for cleared US dollar interest rate derivatives from fed funds to SOFR. This transition is expected to happen in October 2020.

The switch to €STR and SOFR PAI and discounting will result in a valuation change for affected contracts. This transition will not have any impact on the contract coupon payments, which are linked to their original benchmark rates. Despite the changes in valuation and risk due to this switch, the CCPs will use compensation mechanisms so that individual participants will experience almost no ‘net’ changes.

While the discounting and PAI switch will not affect the reference rate for swaps, this transition will be important for further embedding €STR and SOFR within the derivatives market and driving liquidity in these products.

For example, as dealers usually hedge their discounting liabilities, they are likely to start using SOFR-based products instead of fed funds swaps and futures following the switch to SOFR discounting and PA. Therefore, this transition to SOFR discounting is expected to create additional trading in SOFR OIS, EFFR-SOFR basis swaps and SOFR futures.

As CCPs issue compensating/hedging EFFR-SOFR basis swaps with longer maturities as part of the transition to SOFR discounting, the unwind/auction of these swaps by market participants that choose to do so will drive day-one activity in these swaps. It is expected to extend the tenors of SOFR swaps and create liquidity across the entire SOFR curve. Currently, most SOFR transactions have duration up to one year.

Market participants will need to make internal reporting changes to transition their own profit
and loss and risk management for euro- and US dollar-denominated cleared derivatives to €STR and SOFR discounting to be able to correctly value their trades in the new discounting regime. As market participants would seek to re-hedge their discounting risk, they will need to prepare to trade, book and risk manage basis swaps based on the new RFRs.

After CCPs make the switch to new discount curves, market participants may also consider the switch for their non-cleared trades to keep them consistent with cleared portfolios, says ISDA. This will involve a renegotiation of existing credit support annexes. In bilateral contracts, interest paid on collateral is negotiated by the counterparties. US dollar-denominated instruments are typically, but not exclusively, based on EFFR. Similarly, euro-denominated instruments are typically based on EONIA. The change from EFFR to SOFR and from EONIA to €STR in bilateral contracts will create changes in value and risk, which would need to be addressed by counterparties.

Exposure to USD LIBOR

Based on the Alternative Reference Rates Committee’s (ARRC) estimates, the outstanding gross notional of all financial products referencing US dollar LIBOR was about $199 trillion at the end of 2016, including $145.0 trillion of OTC derivatives, $45 trillion of exchange traded (ET) derivatives and $8.3 trillion of cash products.

Roughly 77% of OTC derivatives, 99% of exchange traded derivatives and 71% of cash products notional outstanding is expected to mature before 2021 (see Chart 1). This leaves about 23% of OTC derivatives and 29% of cash products with total outstanding gross notional of about $37 trillion to mature after 2021.

Market participants still continue trading LIBOR-based derivatives. US dollar LIBOR transactions accounted for about 47% of interest rate derivatives (IRD) traded notional in the US during 2019. RFR transactions, including SOFR, SONIA, the Swiss Average Rate Overnight, the Tokyo Overnight Average Rate and €STR, accounted for 3.4% of total IRD trading activity in 2019.

The ISDA Research Note on Adoption of Risk-Free Rates: Major Developments in 2020 can be found at: https://www.isda.org/a/WhXTE/Adoption-of-Risk-Free-Rates-Major-Developments-in-2020.pdf

Julie Ros

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