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The recent EUR Price Alignment Interest (PAI) and discounting
switch from EONIA to €STR for cleared derivatives is now in the
books. From 27 July 2020, any EUR cleared swap or EUR swaption
delivering a cleared swap follows the conventions set by the
clearing houses (e.g. CME, Eurex, LCH) and €STR is now the standard
rate for discounting those instruments.
The new EUR PAI and discounting conventions delivered €STR
discounting risk to all parties involved in cleared derivatives. On
the switch day, price transparency and compensation calculation
were made simpler thanks to the fixed 8.5bps spread between EONIA
and €STR. Due to their more complex nature, the case for swaptions
required an amendment to the 2006 ISDA Definitions published as
Supplement 64 on March 30, 2020.
It is expected that the upcoming USD PAI and discounting switch
from Fed Funds (or EFFR, Effective Federal Funds Rate) to SOFR
planned for 17 October 2020 will be far more complex due to the
size of the USD cleared derivatives market, the number of firms
involved and the fact that the Fed Funds and SOFR basis is dynamic
which complicates compensation mechanisms involving the delivery of
basis swaps to address changes in risk profile.
It is critical that firms with significant exposure look at
value transfer considerations and assess the impact of this
discounting switch on their portfolios. As we can see from the
graph above, the magnitude and direction of impact can vary
dependent on the portfolio exposure to Fed Funds. Unlike EUR, where
the impact could in practice be forecasted in advance, tracking the
USD basis will be critical for firms hoping for a smooth
transition.
Not only the NPV of USD cleared derivatives will change but also
the risk profile of the whole portfolio (for those who decide to
opt for cash compensation instead of the delivery of basis swaps).
Some imbalances could also appear depending on the number of firms
that decide to opt for full cash compensation versus cash and
physical basis swaps. We are seeing the effects of expected supply
and demand imbalance on the long end of the Fed Funds-SOFR basis
curve that currently trades at a 5.5bps spread.
The PAI switch dates are big milestones in the IBOR transition
plan but they are far from being the only events that firms should
have on their radar. The timing of discounting switch for bilateral
trades is unclear and largely depends on existing CSA agreements.
Assuming liquidity will gradually transfer from IBORs to RFRs, the
last firm to transition a CSA will likely pay a hefty liquidity
premium to execute the transfer. Taking a proactive approach and
monitoring liquidity and PV impact of transitioning trades,
portfolios and CSAs is critical. If liquidity is too low and PV
impact is unfavorable, it might be preferable to wait. If liquidity
is good and PV impact is favorable, the transition should happen
now.
Posted 27 August 2020 by Julien Rey, Executive Director, Financial Services, Head of LIBOR Transition Program, S&P Global Market Intelligence
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