How Covid-19 is impacting transition preparations

Vikash Rughani, TriOptima: I am unable to make predictions on how the market will evolve, but our services provide solutions for any outcome. TriOptima has worked to build its compression service so it stands ready and in prime position to help market participants mitigate any uncertainty  surrounding their over-the-counter (OTC) ICE Libor swap books.

Vikash Rughani: Preparation comes in three steps:

1. Determining your exposure to ICE Libor in terms of trade count, risk, mark-tomarket and counterparty risk
2. Ensuring you are engaged with industry initiatives to continue contractual performance in the event of ICE Libor discontinuation, determine their appropriateness for your trades and act accordingly. This may start by looking at industry-derived fallback language and the associated protocol
3. Considering whether the fallbacks or amended contract language satisfies your needs, or how you might proactively manage your exposure as soon as possible so you have greater certainty now, regardless of any potential transition.

Central to determining this exposure is understanding all the various nuances that determine the true exposure to ICE Libor across jurisdictions, counterparties, index periods and across cash and derivatives transactions. Also, you should take account of how actively ICE Libor is traded across the organisation today. Another key part of understanding ICE Libor exposure is the hedge accounting and tax treatment of various trades in a portfolio. A great deal has been made of the vast amount of notional tied to the ICE Libor benchmark but, in practice, much of that notional is sticky, with other implications inhibiting one’s ability to simply remove or convert trades in isolation. 

Furthermore, fallbacks will be a vital seatbelt for market participants, but they will not solve all the challenges of uncertainty and risk. Holders of ICE Libor exposure will still be subject to interim market moves and  taking snapshots at arbitrary points in time without any control. 

If market participants choose to convert some of their ICE Libor swaps portfolio now, they can do so through a combination of termination and risk replacement into the alternative risk-free rate (RFR). This can take place through bilateral execution in the market or through services such as triReduce, which allows bulk compression and conversion of ICE Libor exposure at each participant’s own midmarket valuations. By taking this approach, market participants can compress gross notional down to the core net risk position while ICE Libor trading continues, and convert trades to reference the alternative RFR within risk-based limits defined by each firm and based on a common toolkit available to all market participants.

The value comes from not having to cross bid/offer when converting interest rate swaps exposure into the alternative RFR, and doing so in a controlled iterative manner rather than exposing one’s full position to the market. Those firms that can bulk terminate, amend and book replacement trades, or leverage central counterparty (CCP) messaging for such transactions without operational constraints, will find themselves best placed for the orderly conversion that will deliver greater certainty for their interest rate swap books.

Vikash Rughani: The challenges related to the euro short-term rate (€STR) discounting switch in July and the US dollar secured overnight financing rate (SOFR) discounting switch in October vary greatly. In the switch between the euro overnight index average (Eonia) and €STR, there is a known fixed spread – 8.5 basis points. For SOFR, the spread between Federal Reserve funds and SOFR is variable, albeit at vastly lower levels based on historical data. 

Some ways firms are preparing for this change is by mitigating the impact of the change and preparing for life after the change. The discounting switch is seen in both jurisdictions as a method of increasing adoption – through new hedging and trading activity – of the €STR and SOFR alternative RFRs. 

With regard to mitigating the impact of the change, firms are looking at the potential of recouping their existing trades, driving down variation margin (VM) and risk sensitivity to the discounting curve. This may not be an option available to all market participants, depending on their goals – the intention being to reduce the VM and risk change of a switch from one discounting curve to another. 

We are speaking with our customers about ways in which we can help reduce the impact of the discounting switch, but the weeks before the discounting switch will be the time any such mitigating actions will need to be taken, either bilaterally or multilaterally. 

Following the discounting transitions, each new euro or US dollar interest rate trade – and non‑deliverable currencies in the case of LCH – cleared will be subject to discounting at the new curve. So, inherently, firms used to hedging their risk to discounting will look to hedge that exposure on a periodic basis – in turn adding trading activity to the alternative benchmarks, which will then feed greater efficiency into those markets. 

From a triReduce perspective, we compress both €STR and SOFR swaps and see any additional liquidity as new opportunities to compress and deliver greater capital efficiencies for our customers. As a second-order effect, the added liquidity will also help any steps to convert into these alternative RFRs, since the more liquidity there is, the greater ease the market will have in performing the conversion. 

The other way firms are preparing is by planning for renegotiating their bilateral credit support annexes (CSAs) to remove this consequential source of basis risk between cleared and non-cleared exposures. The market has worked at length to implement mechanisms to handle the impact of swaptions exercising and the mandate to clear, but the question of discounting comes up every time bilateral counterparties consider backloading a trade into clearing.