“Big Bang” SOFR Discounting & Price Alignment Transition Discussion Document

The USD swap market is currently evaluating the approach for transitioning the discounting and price alignment of USD swaps from Fed Funds (EFFR) to SOFR. Originally, in October 2017, the ARRC laid out this transition to occur over a period of 18 months via Steps 4 and 5 of the Paced Transition Plan:

Step 4 – CCPs provide market participants the choice of selecting either EFFR or SOFR discounting and price alignment on all USD swap products beginning Q1-2020.

Step 5 – CCPs no longer accept new swap products referencing EFFR discounting and price alignment except for the purpose of closing out or offsetting legacy positions and risk.

However, certain market participants have expressed a preference for a “big bang” transition of discounting and price alignment, whereby the industry would agree on a protocol for this transition that would be implemented across legacy and new cleared transactions on a single date. This would likely occur during the 2nd half of 2020.

The advantages of a “big bang” approach include that all participants would be making the change at the same time, which removes the need to cross bid/ask spreads and avoids the bifurcation of liquidity as well as the operational complexities associated with managing multiple USD discounting curves. CME is also supportive of a coordinated “big bang” discounting/price alignment change as it will result in an immediate pickup in SOFR liquidity throughout the curve, which is the most common concern raised by clients when discussing SOFR adoption.

Following a series of bilateral conversations with industry participants, we believe the industry needs to reach consensus on the following issues relating to a “big bang” approach:

1.  Scope: Should this include all products with a USD funding component, or should it be limited to USD IRS?

a. Starting with USD IRS only – easier to build consensus with a smaller group of individuals that have a vested interest in building liquidity in SOFR.
b. Including all products with a USD funding component – increases the SOFR liquidity pool and facilitates hedging discounting risk on a comprehensive basis across all products.

2.  Timing: When is the best time to implement a “big bang” approach?

a. July and August - typically heavy vacation times
b. September and October - conflict with the expansion of Uncleared Margin Requirements
c. November – US elections
d. December – technology freezes and holidays.

3. Cash Compensation: The working assumption is that CCPs will conduct a special cycle to facilitate the change in discounting rate, and a corresponding cash adjustment to reverse out any PNL impacts associated with this change (avoiding the creation of winners and losers). Do you agree with this approach?

4. Risk Exchange: Based on conversations with industry participants, we believe that this should be optional and most likely managed by a 3rd party, as many clients do not hedge discounting risk and those who manage discounting risk frequently do so across CCPs and uncleared exposures.

5. Handling of legacy Swaptions positions that typically expire into cleared IRS: What is the best way to handle these trades given that they are not currently cleared (subject to the cash compensation protocol) and that the expectation at the time of trade was that the underlying swap would be cleared with EFFR discounting and price alignment?

We strongly recommend having an open industry conversation (ARRC Paced Transition/Market Structure WG) on these items to help build consensus and support for a “big bang” approach.

 

For Discussion Purposes Only
www.cmegroup.com/sofrswaps

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