Other parts of this series:
Our previous post looked at implications of the Central Clearing Counterparty (CCP) Discounting Switch when it comes to risk management, IT infrastructure and process readiness. For this final blog post of the series we will explore how the CCP Discounting Switch should affect bilateral and internal trading, in addition to the trading volumes of the new risk-free rate (RFR)-based products.
Bilateral and internal trading
While the discounting switch is driven by CCPs, and the discounting and price alignment interest/price alignment amount (PAI/ PAA) is planned to only change for EUR and USD-referencing cleared interest rate swap products, market participants are strongly encouraged to define a strategy for trades with bilateral counterparties and internal trading, e.g., inter-entity interest rate swaps (IRS) trades, as their discounting is not expected to automatically switch in line with CCPs. This is important because many financial institutions may have links between internal trades (inter/intra-entity trades) and external hedges cleared via CCPs. For example, some financial institutions have internal hedging activities between Asset and Liability Management (ALM) and the Investment Bank (IB). The IB subsequently decides if they want to take the interest rate risk (IRR) on their own books or pass it on to the market via external cleared swaps. Financial institutions may also trade interest rate swap products bilaterally over-the-counter (OTC) with each other.
Figure 1 below shows that financial institution B has a bank-internal IRS (trade 3) between its IB division and its ALM division. As the IB of financial institution B does not want to keep the IRR on their books, they decide to pass it on to the market via an external, cleared IRS (trade 1, leg b). Consequently, the internal IRS trade 3 is directly linked to the institutions’ leg “b” of the centrally cleared IRS trade 1. The CCPs discounting switch should only affect the cleared trade 1 while internal trade 3 should not be directly impacted (unless institution B decides to change discounting on trade 3 on the same day). This is expected to cause a mismatch of trade 3 to trade 1b and disrupt the hedge relationship.
Figure 1: Bilateral and internal trading (high-level view)
As a first step, bilateral trades and internal trades linked to CCP-cleared interest rate swap products should be identified and run-off profiles analyzed. Market participants should then consider the impact of the switch on their non-cleared exposure and articulate a consistent switchover approach and timeline with regards to their (linked) cleared trades that are affected by the discounting switch. This should require renegotiating existing credit support annexes (CSA), and as is the case in bilateral contracts, the interest paid on collateral is negotiated by the counterparties. This may also expose market participants to conduct risk. Accenture has published a document on LIBOR conduct risk in April 2020 that outlines key considerations to mitigate conduct risk. It is unlikely that all negotiations with bilateral counterparties can be aligned to the CCP discounting switch timeline, therefore a phased approach seems more reasonable. This should lead to a temporary multi-curve discounting environment within institutions and may cause additional operational complexity in risk management and IT infrastructure to be managed accordingly.
A transition roadmap and strategy for internal as well as bilateral trades should also be prepared. Once the bilateral arrangements with all counterparties are agreed to, changes should be executed and records of the changes maintained in corresponding legal documentation systems and respective collateral management systems.
Trading volume and liquidity in new RFRs
The CCPs discounting and PAI/ PAA switch is expected to drive increased trading volume and liquidity in the Euro Short-term Rate (ESTR) and the Secured Overnight Financing Rate (SOFR)-referencing products across the industry. In Q1 2020 the traded notional value of interest rate derivatives referencing new RFRs accounted for only 9.6 percent of total interest rate derivatives’ traded notional value.1 A rather low volume considering the trillions of dollars benchmarked to Interbank Offered Rates (IBORs) and the target date for final LIBOR-cessation in less than two years. Accordingly, the discounting switch is crucial to further embedding ESTR and SOFR within financial markets and driving liquidity in ESTR- and SOFR-referencing products.
The International Swaps and Derivatives Association (ISDA) expects that with the CCPs’ discounting switch, the tenors of SOFR-referencing swaps can extend and create liquidity across the entire SOFR curve as CCPs issue Effective Fed Funds Rate (EFFR)-SOFR basis swaps with longer maturities.2 The sell/auction of some of these swaps by market participants should quickly drive trading activity and liquidity in these swaps and tenors. Moreover, financial institutions usually hedge their liabilities to reduce the volatility of assets relative to the present value of liabilities due to changes in discount rates. This should create additional trading activity in ESTR and SOFR-referencing interest rate derivatives as well as EFFR-SOFR basis swaps.
As the discounting switch is expected to trigger an industry-wide move from EUR/USD-LIBOR referencing products to SOFR/ESTR-referencing products, market participants should be ready to trade the new RFR-referencing products prior to the final LIBOR cessation on the 31st of December 2021.
The CCPs discounting and price alignment switch from the Euro Overnight Index Average (EONIA) to ESTR and from EFFR to SOFR is expected to be a key milestone in the LIBOR transition journey.
It is critical that market participants identify their precise exposure to affected and cleared EUR and USD-denominated interest rate swap products, decide on their preferred discounting risk exposure, agree on compensation mechanisms with CCPs and prepare a switch-over runbook for risk management outlining key tasks around their “Go-Live.” Moreover, market participants’ front-to-back infrastructure should be ready and able across the business and IT to mitigate financial and non-financial risks arising from the discounting switch. A resulting interim multi-curve discounting environment, caused by bilateral and internal trades, should create additional complexity, but can be addressed via a sophisticated switchover strategy. Although the switch does not affect the interest rate derivatives’ reference rates, this change is crucial to further embedding SOFR and ESTR within the financial markets and driving significant liquidity as well as trading activity in the LIBOR successor rates.
To find out more on the topic and how we can help you along your LIBOR transition journey, please contact Ossip Hühnerbein or Christian Kirch. For reference, you can also read about our 2019 LIBOR Study.
Newsletter Contact Person: Venetia Woo
1“Interest Rate Benchmarks Review: First Quarter of 2020”, International Swaps and Derivatives Association, April 2020. Access at: https://www.isda.org/a/k6qTE/Interest-Rate-Benchmarks-Review-First-Quarter-of-2020.pdf?_zs=AgwRO1&_zl=EF8j5.
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