6 minute read 11 Jul 2020
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Four key implementation priorities for IBOR transition in 2020 and beyond

By Jan Rosam

EY Germany Financial Services Consulting Capital Markets & Emerging Technology Leader; Brexit & IBOR Transition Leader

Transformation and technology leader in capital markets. Passionate about emerging technologies, coding and math. Father of two, sailor and gravel biker.

6 minute read 11 Jul 2020

Following market developments and preparing for IBOR transition can keep you and your clients on track for the future.

In brief
  • Preparing for the Interbank Offered Rate (IBOR) transition must be a primary business focus for the rest of 2020.
  • It’s time for action now – even greater challenges await in 2021. Clear communication with counterparts and clients is crucial.

A new era of interest rate benchmarks in Europe was hailed as a milestone in October 2019. It marked a transition from the Euro OverNight Index Average (EONIA) to €STR (Euro Short-Term Rate)– giving market participants less than two years until 3 January 2022 to phase-in their implementation.

In a previous article, How €STR is the start for a new era of euro interest rate benchmarks, we described the details of financial institution readiness and the challenges, impacts and technical steps that have been implemented since the journey began in 2017.

This article discusses the upcoming central counterparty (CCP) discounting switch in EUR and USD. This discounting switch is an essential step toward the overall IBOR transition and most likely the core action in the over the counter (OTC) derivative market due in 2020.

1. EUR CCP discounting switch – the facts

Initially planned on 22 June 2020 and now shifted to 27 July 2020 the European CCPs will change the valuation of all EUR-denominated OTC-products from Euro OverNight Index Average (EONIA) to Euro Short-Term Rate (€STR). During this transition, the valuation shift, resulting from a change in the discount curve, will be compensated by cash payments.

Additionally, the interest on collateral (price alignment interest or price alignment amount) was amended to €STR as well. Whereas the EUREX is handling the cash compensation as simple payments, London Clearing House (LCH) will book a new 1 EUR trade with a short maturity and attaches the cash compensation amount to the 1 EUR trade.

2. EUR CCP discounting switch – the preparations

Most market participants started to prepare detailed run books for the transition in Q1 2020, and many of them are now using the originally planned switch date in June for a complete run through. Detailed reports provided by the CCPs already show the valuation change on a trade level basis and allow the simulation and aggregation of effects.

To reduce complexity before the actual discounting change, many market participants have started portfolio compression runs and will continue to do so. This not only includes external trades but also internal trades between different trading and investment books. If market participants are experienced in running such compressions, this will provide a great opportunity of lowering the number of deals and therefore, the necessary amendments.

Speaking of internal trades, many market participants are planning to change the internal deal valuation on the same date and thereby ensure that both internal and external cleared trades will follow the same valuation logic. Many market participants have already started to assess the impact on the trading and investment books as well as on the market risk VaR. Even experienced market participants with years of experience have found numbers that they could not explain right away and needed further drill downs as well as subsequent IT changes to ensure a smooth and foreseeable transition.

In particular, the accounting treatment and front office booking logic not only for external, but also for internal trades remain a challenge for most of the market participants, as different front office and accounting systems will require different approaches to achieve the desired outcome.

Despite these issues, the transition of the client clearing business will remain a challenge as well. The CCPs will calculate the necessary valuation changes and determine the cash compensation on a trade level basis but clearing brokers must manage the communication and booking process for their clients. Many clients expect to be part of the testing in June or demand separate test dates.

3. USD CCP discounting switch – the facts

As of today, the discounting change for USD is planned to take place on 19 October 2020 and will not only cover USD denominated products, but also Mexican New Peso (MXN) denominated products and all products in non-deliverable currencies.

In contrast to the EUR CCP discounting switch, the USD discounting switch from Effective Fed Funds Rate (EFFR) to Secured Overnight Financing Rate (SOFR) will not benefit from a constant spread between the old and new rate.

Therefore, in addition to the cash compensation resulting from the change in the discounting curve from EFFR to SOFR, risk-offsetting trades will be booked in six different buckets ranging from two to 30 years. Each bucket will be assigned one fixed vs. SOFR trade and one fixed vs. EFFR trade. Those risk-offsetting trades ensure a similar risk position after the discounting switch. The necessary prices for the new trades will be determined in an auction, where all direct members can participate on a voluntary basis. But LCH expected leading market participants to take a pro-active roll.

Please note that the approach of using risk-offsetting trades will only be used by LCH. EUREX will not use this approach and will only book cash compensation. Therefore, the risk position will not be the same after the discounting switch. Further details are available on the respective websites of LCH, EUREX and Chicago Mercantile Exchange (CME).

4. USD CCP discounting switch – the preparations

The process to book and account for the cash compensation payments is expected to follow the same logic as the EUR compensation payments. Therefore, many market participants are expected to copy the run book from the EUR CCP discounting switch. The only major difference is the handling and booking of up to 12 risk-offsetting trades (six buckets, each having two trades).

Furthermore, complexity is resulting from the changing spread between EFFR and SOFR; therefore the compensation payments are changing on a daily basis. Many market participants have started to reduce the market exposure to lower potential valuation and risk effects on a portfolio basis.

Another major change will apply to client clearing, where clients will have the option to choose a cash only compensation – based upon auction prices – and not to obtain any risk-offsetting trades. This choice seems simple at first, but clients will be exposed to the outcome of the auction. Where clients select to obtain risk-offsetting trades, the clients should simulate any resulting trades beforehand using the tools provided by LCH and the clearing broker. Breaching the limits set by the clearing broker should be avoided as back office operations at leading clearing house brokers will have a tough time accounting for all bookings and reporting.

Some clearing brokers are already outlining a support offer to their clients, by which the clients could opt out of the risk-offsetting trades and trade individual risk-adjusted SOFR- EFFR basis swaps with the clearing broker before or after the CCP switch date and with adjusted nationals.  

This article is co-authored by Christian Rump, Chartered Financial Analyst, Ernst & Young GmbH, Germany.

Summary

In spite of the other challenges resulting from the COVID-19 pandemic as well as split and remote operations, market participants must remain focused on the CCP and discounting transition in EUR and USD. Simulation engines as well as a detailed run book should be in place already. Communication to clients and counterparties will be a priority.

This is the year for changing the discounting regime, and all efforts must be joined to fulfill this goal. No work can be left behind, as 2021 will be the year for even greater work and challenges – including the actual replacement of USD-LIBOR and GBP-LIBOR.

About this article

By Jan Rosam

EY Germany Financial Services Consulting Capital Markets & Emerging Technology Leader; Brexit & IBOR Transition Leader

Transformation and technology leader in capital markets. Passionate about emerging technologies, coding and math. Father of two, sailor and gravel biker.