The two most important Central Counterparty (CCP) Clearing houses in the world, the Chicago Mercantile Exchange (CME) and the London Clearinghouse (LCH) have laid out preliminary proposals for the valuation and risk transition for the discounting switch to the Secured Overnight Financing Rate (SOFR) for a variety of cleared USD-denominated interest rate products. This event has become known as the CCP ‘single-step’ within the London Interbank Offered Rate transition community and is expected to help boost SOFR linked liquidity as organizations will need to hedge balance sheet size interest rate risk.
On June 2nd 2020 the Commodity Futures Trading Commission Market Risk Advisory Committee’s (MRAC) Interest Rate Benchmark Reform Subcommittee (Subcommittee) held a virtual table top discussion regarding CME Clearing (CME) and LCH Limited’s (LCH’s) single-step proposals for the transition of discounting and price alignment interest for certain products to the secured overnight financing rate (SOFR), scheduled for October 2020.
Both CCP’s have broadly similar mechanisms for the transition and are targeting an October 2020 date. The current plan is to consolidate all the feedback and lessons learned at the virtual table top and then present to the full MRAC subcommittee with a view to providing a publicly available paper in the coming months.
At a high level, the mechanics of both proposals involve a cash compensation component as well as the booking of a basis swap to achieve risk neutrality for the CCP’s. Both proposals involve the CCP’s conducting a standard end-of-day valuation cycle, moving variation margin and cash payments that are currently calculated with the Effective Federal Funds Rate (EFFR) yield curve discounting. After this standard cycle is completed, the CCP’s will conduct a special cycle in which the same positions will be valued off of a SOFR based yield curve. The following adjustment will be comprised of two components:
(1) a cash adjustment that is equal and opposite to the change in each cleared swaps Net Present Value (NPV) and
(2) an EFFR / SOFR basis swap which would be booked by the CCP’s to participants accounts at closing market curve levels which would have the effect of restoring participants to the their respective original risk profiles.
This design is intended to leave the CCP’s with no residual risk. Thereafter, the CCP’s would utilize SOFR discounting on all USD-denominated swap trades. Both CME and LCH currently intend to provide their clients with the option to opt out of being a counterparty to the EFFR / SOFR basis swap and their current plan involves the use of third-party market markers to facilitate risk transfer.
This important and necessary change will present risks for organizations who transact in cleared interest rate products. Unlike many other regulatory and market structure style changes, this is the first time that this type of event has occurred which presents a heightened level of uncertainty. There are a number of considerations that an organization preparing for this change should consider.
1. Prepare for an appropriate range of scenarios. What are the implications of investors electing to forgo the basis swap and opting for only the cash adjustment? What if there are not enough market markers to provide a deep enough market to absorb institutional size parcels in EFFR / SOFR basis risk? How will movements in the direction and shape of the EFFR / SOFR basis curve impact an organization during the CCP switch? Organizations should hold brainstorming sessions with representation from across the enterprise to identify various scenarios which will enable a thorough and holistic risk identification process to occur. A strategy must be developed for handling the basis swaps for the SOFR discounting transition.
2. Identify key risks and implement mitigating controls. Organizations should prepare for the CCP switch by identifying a range of potential financial and non-financial risks and implementing mitigating controls. Further, even slight variations in the approach and methodology of the switch by the CME and LCH will be a complexifier for organizations. The MRAC’s Interest Rate Benchmark Reform Subcommittee at the Commodity Futures Trading Commission called for maximum synchronization between the two CCPs during the switch. Firms with more strategic LIBOR transition programs will consider conducting a CCP switch specific internal audit of the associated control environment prior to the October 2020 switch.
3. Execute an ad-hoc swap compression exercise. Many financial institutions run regular swap compression exercises as a risk reduction practice which compresses portfolios and frees up capital. Third party intermediaries offer automated services to help facilitate this. The advantage of this is that controlled two-way (pay and receive) swap activity can occur to terminate substantial amounts of swap contracts before they expire by their terms. A swap compression activity prior to the CCP switch would reduce CCP credit exposure, operational risk and cost, as well as lower any potential legal and administrative expenses.
4. Engage with and provide feedback to the CCP’s – Both the CME and the LCH have published their respective SOFR switch proposals and associated guidance for market participants. Organizations must study these proposal and use the CCP’s request for feedback as an opportunity to raise any concerns as well as to propose modifications that minimize risk for the broader market.Educational webinars and contact details of relevant individuals at the CCPs are publicly available. Firms with representation of the Alternative Reference Rates Committee could consider raising concerns in that forum.
5. Create an enterprise wide CCP ‘Single-Step’ playbook – Once an organization has identified key risks across a range of scenarios, a playbook should be produced which documents these risks and mitigating controls. A basis swap during the normal course of business would be booked in an organization’s front end trade capture system however the EFFR / SOFR basis swap being proposed by the CCPs will be booked by the CCPs and so the risk will not flow to market participants in the usual way. An understanding of the practical and operational challenges associated with this type of trade entry across the trade lifecycle should be gained and documented in the CCP ‘Single-Step’ playbook. The comprehensiveness and complexity of the playbook should be commensurate with the risk size and business mix of the organizations cleared products exposure.
“The CCP discounting shift in October 2020 marks a fundamentally important event in the transition to robust alternative reference rates.”Tom Wipf, Vice Chairman of Institutional Securities at Morgan Stanley and Chair of the Alternative Reference Rates Committee, June 2nd, 2020
6. Leverage your organizations LIBOR transition program governance structure – Organizations should utilize the governance structure and associated roles and responsibilities that have been set out as part of the Board approved LIBOR transition program plans. A firms preparedness, risks and mitigating controls associated with the CCP switch should be included as an agenda item in management team updates and key committees such as the asset-liability committee, risk, and the board.
Although global IBOR transition is evolving at varying speeds across geographic financial jurisdictions, this event will occur by in large synchronously so will require multinational organizations to ensure coordination across international office locations. The risks to an organization and to the broader market in failing to be fully prepared for this important change should not be underestimated.
Mr Burnett is the Director of SOFR Academy and is based in New York.