Other parts of this series:
Our first blog in this series explained why the Central Clearing Counterparty (CCP) Discounting Switch represents a key milestone in financial firms’ transition from LIBOR. In this second post we will discuss the implications of the CCP Discounting Switch on market participants’ risk management function, their IT infrastructure and their process readiness.
With the CCPs proceeding and executing an extensive discounting and price alignment interest/price alignment amount (PAI/PAA) switch from the Effective Fed Funds Rate (EFFR) to the Secured Overnight Financing Rate (SOFR) in October 2020, and from the Euro Overnight Index Average (EONIA) to the Euro Short-term Rate (ESTR) in July 2020, on all existing and new cleared EUR and USD-denominated interest rate derivatives, market participants should be ready, and may have to accelerate their Interbank Offered Rates (IBOR) programs.1
Risk management implications
The discounting switch should induce a change in the risk profile of market participants’ portfolios. As for the affected USD-denominated contracts, the EFFR discounting risk becomes a SOFR discounting risk at the point of conversion. Subsequently, valuation sensitivity is derived from the SOFR curve. Market participants should decide whether they prefer to hedge the new SOFR discounting risk with the provided EFFR-SOFR basis swaps back to EFFR discounting risk, or instead move to SOFR discounting and sell the basis swaps on the conducted auction for a lump sum cash payment.
This ties back to institutions’ strategic decision on whether to remain on EFFR discounting or move to the new SOFR discounting. Based on this decision, institutions may have to adjust their internal risk management framework as well as limits and targets for profit and loss and risk reporting. If institutions decide to stay on EFFR discounting (and re-hedge SOFR discounting risk), moving forward they should prepare the future hedging of all new cleared EUR/USD contracts via EFFR-SOFR basis swaps.
As for the EONIA to ESTR switch, the risk management function should process the impact of cash compensation and the switch from ESTR+8.5bps to ESTR flat.
Furthermore, the impact of the discounting switch on hedge accounting relationships should be assessed and prepared, as the change should lead to additional inefficiencies, either at the time of the change (EONIA/ESTR) or over time (EFFR/SOFR).
It is critical that all market participants properly identify their precise exposure to affected and cleared EUR and USD-denominated interest rate swap products. In our view they should also come to an agreement on compensation mechanisms with CCPs and prepare a switch-over runbook for their risk management function that outlines key tasks around the switch dates.
Infrastructure and process readiness implications
Trading new risk-free rate (RFR)-linked products requires front-to-back (F2B) integration in front office, operations, finance and risk systems. The time required to complete a proper business and IT analysis, and development and testing, should not be underestimated, especially if dependencies to external software providers exist or legacy IT systems are still used.
With this in mind, market participants should conduct an extensive review of their current IT processes, procedures documentation, product structures, booking models, affected IT systems and applications as well as software dependencies. Once the impact of the discounting switch on the F2B flow is identified, the required IT configuration and development work has to be performed. This includes the construction, setup and support of new ESTR flat/SOFR discounting curves, the setup and support of new RFR-based products, and the setup of new static data (counterparties/books), which is linked to the new discounting curves.
Additionally, institutions should prepare their risk and reporting systems to be able to correctly value and report their exposure in the new discounting regime. All changes should be tested F2B in a test environment before they can be released into production. The CME plans to offer market participants access to their test environment so institutions can align their operational F2B processing and simulate the impact of the discounting switch on their portfolios.2 Finally, institutions may have to migrate or re-book affected and cleared EUR and USD-referencing trades to new ESTR/SOFR static data.
To master the discounting switch from an IT infrastructure and process point of view, it is crucial that financial institutions budget enough resources and define an operational readiness strategy based on the target dates when the steady state is anticipated to go live.
In the last blog in this series we will discuss how the discounting switch affects bilateral and internal trading as well as trading volumes in new RFR-based products.
- “Transition to €STR Discounting: Updated Timing,” LCH Group, April 17, 2020. Access at: https://lch.com/membership/ltd-membership/ltd-member-updates/transition-to-%E2%82%ACSTR-Discounting-Updated-Timing. “SOFR Discounting: LCH Plan for the SwapClear Compensation Process,” LCH Group, Q4 2019. Access at: https://www.lch.com/sites/default/files/media/files/SOFR-Discounting.pdf “SOFR & €STR Discounting Transition Process For Cleared Swaps,” CME Group, June 2020. Access at: https://www.cmegroup.com/education/articles-and-reports/sofr-price-alignment-and-discounting-proposal.html.
- “SOFR & €STR Discounting Transition Process For Cleared Swaps,” CME Group, June 2020. Access at: https://www.cmegroup.com/trading/interest-rates/files/discounting-transition-proposal-mar-2020.pdf.
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