The CCP Discounting Switch is a key LIBOR milestone. This first blog in our series describes the changes and outlines transition timelines.

The transition from LIBOR promises to be both challenging and demanding. This three-part blog series will explore issues surrounding the Central Clearing Counterparty (CCP) Discounting Switch. This first blog introduces the topic, explaining changes and outlining transition timelines. Part 2 touches on the implications of the changes for market participants. The final blog explores how the discounting switch is expected to affect bilateral and internal trading as well as trading volumes in new risk-free rates-based products.   

Introduction 

As the spread of the COVID-19 pandemic continues, so does the threat faced by the world’s economy, financial institutions and other market participantsThe Financial Conduct Authority (FCA) recently stated“The central assumption that firms cannot rely on LIBOR being published after the end of 2021 has not changed and should remain the target date for all firms to meet.”1 

A key milestone in 2020 for the industry-wide transition from LIBOR and other interbank offered rates (IBORs) to alternative risk-free rates (RFRs) is the discounting switch on all cleared EUR and USD-denominated interest rate swap products by central counterparty clearing houses (CCPs).  

The discounting switch is important to drive liquidity in RFR products.

Trading of interest rate swap products (IRS), overnight indexed swaps (OISs), forward rate agreements (FRAs), basis, zero coupon swaps (ZCSs), swaptions and other derivatives are usually completed using  CCPs as intermediaries, given regulators require mandatory clearing for the majority of these contracts in order to maintain financial market stability. CCPs bear the counterparties’ credit risk when clearing and settling market transactions as this helps decrease default risk while “smoothing” operations. To mitigate default risk, CCPs demand collateral deposits (initial margin and variation margin) from the counterparties of a cleared derivative contract. Whenever an underlying interest rate (or other underlying asset) moves and changes the value of a contract, counterparties transfer/receive collateral to/from the clearing house (variation margin). In return for those daily deposits, the delivering party receives a price alignment interest (PAI), sometimes also referred as price alignment amount (PAA), to cover the loss of interest on the posted collateral.

The common post-global financial crisis approach to pricing and valuation of interest rate swap products is based on overnight rates rather than the LIBOR rates, which the derivates reference in order to determine cash flows.2 This is because OIS rates, such as the Effective Fed Funds Rate (EFFR) for USD-denominated contracts or Euro Overnight Index Average (EONIA) for EUR-denominated contracts, contain less credit risk than unsecured IBORs with long tenors.3  Consequently, these OIS rates are used to calculate the PAI/PAA and for discounting the derivatives.  

To develop new, liquid, alternative RFR markets that can serve as future benchmarks for the global financial industry, working groups (WGs) addressing the topic have recommended in their LIBOR transition plans that CCPs should switch the discounting rates of cleared derivatives from OIS to RFRs as early as possible.4 The discounting switch is important to drive liquidity in RFR products, which in turn is required for the actual switchover of contracts’ IBORreferencing rates to new RFRs, for which pre-cessation triggers and fallback language is to be applied.5

Discounting switch timeline

Following the WGs recommendation, CCPs announced that they would be updating the rates used for determining PAI/PAA and the discounting on all EUR- and USD-denominated and cleared interest rate swap products.6  

The LCH Group, CME Group Inc., and the Eurex Group announced they plan to switch discounting and PAI/PAA on all EUR-denominated interest rate swap products from EONIA to the Euro Short-Term Rate (ESTR) flat (no spread) on the 27th of July 2020.7  

The target date for the discounting and PAI/PAA switch on all cleared USD-denominated interest rate swap products from the EFFR to Secured Overnight Financing Rate (SOFR) was announced by LCH and CME to be on or around the weekend of 17/18 October 2020.8 

For GBP, CHF and JPY-referencing cleared interest rate swap products like Sterling Overnight Index Average (SONIA), Swiss Average Rate Overnight (SARON) and Tokyo Overnight Average Rate (TONAR), these are already being used by CCPs for the determination of PAI/ PAA and the discounting.9  

What is expected to change  

The discounting switch shall affect valuation and risk changes for cleared EUR or USD-denominated interest rate swap products. Valuation gains or losses on EUR and USD- denominated contracts should be compensated by CCPs so that market participants’ portfolios experience no changes in their net valuation at the point of conversion.10 As for coupon payments, these should not be affected as they link to the contracts’ referencing rates. 

To facilitate the EONIA to ESTR switch without any value transfers, LCH and CME plan to apply cash compensation payments to all affected contracts opposite of their net present value change.11 This is possible because EONIA is already calculated as ESTR plus an 8.5 basis points spread.12 Consequently, no change is expected in the discounting risk profile of EUR-denominated interest rate swap products as participants remain exposed to the ESTR curve. 

For the EFFR to SOFR switch, CCPs are to offer cash compensation payments and basis swap compensations.13 The CME plans to book a mandatory series of EFFR-SOFR basis swaps into the accounts of affected market participants.14 Those basis swaps should approximately restore participants’ portfolios back to their original discounting risk profile. Participants who do not want to have basis swaps in their portfolios can sell them on an auction facilitated by CME.15 The CME plans to reach out to all affected participants asking for their preferences.16 To neutralize any value transfer upon point of conversion, the CME also plans to apply cash compensation with the LCH following a similar approach.17

The discounting switch shall affect valuation and risk changes for cleared EUR or USD-denominated interest rate swap products.

After the discounting and PAI/PAA switch, all existing and new EUR and USD-denominated cleared interest rate swap products should be exclusively “clean discounted” by new RFRs. This is applicable to IBOR-referencing contracts as well as new RFR-referencing contracts. CCPs are not expected to support dual discounting.18 

In the next blog we will discuss the implications of the CCP Discounting Switch to market participants’ risk management, IT infrastructure and process readiness. To find out more on the topic and how we can help you, please contact Ossip Hühnerbein or Christian Kirch. You also can read about our 2019 LIBOR Study.

To help our clients respond to the global pandemic challenge and outmaneuver uncertainty, Accenture has created a hub of our latest thinking on a variety of topics. You can visit our COVID-19 hub here.

Newsletter Author: Ossip Hühnerbein and Christian Kirch

Newsletter Contact Person: Venetia Woo  

Disclaimer

This blog is intended for general informational purposes only, does not take into account the reader’s specific circumstances, may not reflect the most current developments, and is not intended to provide advice on specific circumstances. Accenture disclaims, to the fullest extent permitted by applicable law, all liability for the accuracy and completeness of the information in this blog and for any acts or omissions made based on such information. Accenture does not provide legal, regulatory, audit or tax advice. Readers are responsible for obtaining such advice from their own legal counsel or other licensed professional. 

About Accenture

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Accenture, its logo, and New Applied Now are trademarks of Accenture. This document is produced by Accenture as general information on the subject. It is not intended to provide advice on your specific circumstances.  
 
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1. “Impact of the coronavirus on firms’ LIBOR transition plans,” Financial Conduct Authority, March 25, 2020. Access at:  https://www.fca.org.uk/news/statements/impact-coronavirus-firms-libor-transition-plans 

2. Adoption of Risk-Free Rates: Major Developments in 2020,” International Swaps and Derivatives Association, February 2020. Access at:https://www.isda.org/a/WhXTE/Adoption-of-Risk-Free-Rates-Major-Developments-in-2020.pdf 

3. “Beyond LIBOR: a primer on the new reference rates”, BIS Quarterly Review, March 2019. Access at: https://www.bis.org/publ/qtrpdf/r_qt1903e.pdf 

4.  “Report by the working group on euro risk-free rates: On the impact of the transition from EONIA to the €STR on cash and derivatives products”, European Central Bank, August 2019. Access at: https://www.ecb.europa.eu/pub/pdf/other/ecb.wgeurorfr_impacttransitioneoniaeurostrcashderivativesproducts~d917dffb84.en.pdf. “Transition from LIBOR, Alternative Reference Rates CommitteeNew York Fed. Access at: https://www.newyorkfed.org/arrc/sofr-transition 

5. Adoption of Risk-Free Rates: Major Developments in 2020,” International Swaps and Derivatives Association, February 2020. Access at: https://www.isda.org/a/WhXTE/Adoption-of-Risk-Free-Rates-Major-Developments-in-2020.pdf. 

6. “Transition to €STR discounting in SwapClear,” LCH Group, September 27, 2019. Access at: https://lch.com/membership/ltd-membership/ltd-member-updates/transition-eustr-discounting-swapclear. “Transition to €STR Price Alignment and Discounting for Euro OTC IRS – Effective July 24, 2010,” CME Group, May 22, 2020. Access at: https://www.cmegroup.com/notices/clearing/2020/05/Chadv20-210.html 

7. “Transition to €STR discounting in SwapClear,” LCH Group, September 27, 2019. Access at: https://lch.com/membership/ltd-membership/ltd-member-updates/transition-eustr-discounting-swapclear“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 & €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. Eurex Clearing Readiness Newsflash | EurexOTC Clear service: A. Updated information for simulation preparation and test of switch from EONIA to €STR B. Changes to level 3 netting (Rate Blending)”, Eurex Group, May 5, 2020. Access at: https://www.eurexclearing.com/clearing-en/resources/circulars/clearing-circular-1972438  

8. “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. 

9. “FCM Regulations of Eurex Clearing AG,” Eurex Group, September 17, 2018. Access at: https://www.eurexclearing.com/resource/blob/1441436/89f0d204c303a424b25cffacb62edef0/data/20180917-fcm-history-4.pdf 

10. Adoption of Risk-Free Rates: Major Developments in 2020,” International Swaps and Derivatives Association, February 2020. Access at:https://www.isda.org/a/WhXTE/Adoption-of-Risk-Free-Rates-Major-Developments-in-2020.pdf. 

11. “Transition to €STR discounting in SwapClear,” LCH Group, September 27, 2019. Access at: https://lch.com/membership/ltd-membership/ltd-member-updates/transition-eustr-discounting-swapclear. “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 

12. About EONIA”, European Money Markets Institute. Access at: https://www.emmi-benchmarks.eu/euribor-eonia-org/about-eonia.html 

13. “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. “SOFR Discounting: LCH Plan for the SwapClear Compensation Process,” Q4 2019. Access at: https://www.lch.com/sites/default/files/media/files/SOFR-Discounting.pdf. 

14. “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 

15. Ibid. 

16. Ibid.  

17. “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. “SOFR Discounting: LCH Plan for the SwapClear Compensation Process,” Q4 2019. Access at: https://www.lch.com/sites/default/files/media/files/SOFR-Discounting.pdf 

18 “Transition to €STR discounting in SwapClear,” LCH Group, September 27, 2019. Access at: https://lch.com/membership/ltd-membership/ltd-member-updates/transition-eustr-discounting-swapclear. 

 

 

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