CCPs’ change to SOFR discounting: What about the bilateral OTC trades?

It is well known that CME and LCH will switch their discounting curves to SOFR for USD instruments. This is set for October. The details of the CCPs’ transition have been well publicised and thoroughly thought through to erase any material economic impact and to ensure changes to risk profiles are minimised.

If an institution is only trading cleared product, this would be the end of their concern. However, most funds have an amalgam of cleared and uncleared product in their derivatives book, begging the question ‘Should I re-paper my CSAs to equally switch my uncleared derivatives discounting to SOFR, and, if so, when?’

In theory, the answer is a resounding ‘yes’, and as soon as is feasible after the CCPs change to SOFR discounting. Practically achieving this requires multi-dimensional considerations.

The basis exposures that would build by trading or holding bilateral instruments discounted with OIS with cleared instruments discounted on SOFR, especially if the cleared instruments were used to hedge (dynamically or statically) the discounting risk on the bilateral position, will be ‘inconvenient’ at best. At worst, which is where risk managers’ brains reside, a confluence of basis risks ensue. Over an actively traded portfolio, it is more likely that these basis risks will be too dynamic or operationally costly to hedge. Opportunely, the SOFR/Fed Funds basis has proved quite stable so far. Severe spikes that were historically seen at quarter and year end have calmed for now, due in part to the additional reserves supplied by the Fed post last September’s dislocations (further increased through March 2020), and multiple other factors beyond the focus of this note.

In practice, the orderly basis affords the industry time to decide on best practices.

Option 1. Decide as a sole entity to re-paper. Being among the first participants to switch will mitigate some of the basis issues, but also introduces new considerations:

• How ready are the main counterparties to deal with many individual requests? Endeavouring to re-paper every one of the CSAs the banks hold is an enormous undertaking, as well as being “system-ready” for all valuation models to identify what discounting curves a client will need, coordinate the valuation and risk impacts and re-book each trade at a time they are working from home, focused on FRTB, the CCPs’ changes to their own portfolios and their business as usual. It is clear the industry is not equipped to switch in entirety ‘shortly after’ the CCPs change their discounting curves.

• How ready is your entity for this undertaking, resources, system modifications, valuation impacts, changes to risk and reporting? Is this ‘readiness’ mirrored with supporting entities, your PB, administrator or similar?

• Liquidity. If we leave this to individual contract holders to renegotiate, we will see a transition period where the market is bifurcated between trading derivatives discounted on one or the other, reducing liquidity in both markets unless the dealers are willing to absorb significantly basis risk, which will be cost prohibitive and unlikely given the current regulatory direction.

• If an entity trading more esoteric derivatives remains on the less liquid discount curve, could this risk migrating level 1 valuations to level 2 (or 3)? Fortunately most swaption screens will quote forward settled prices which means that the CSA being assumed is irrelevant, not all market data is as CSA independent.

• What is the IA or collateral impact of changing, and how set up are your cash management reports to run these what-if scenarios?

• Will leverage naturally increase across the industry whilst counterparties grow additionally cautious about novations and we include additional basis swaps in where they were previously unnecessary.

• VaR and backtesting for market risk and SIMM/UMR. The history of prices we have and calibrate to are all OIS discounted. It is unlikely we would need to recalculate the history of these positions assuming SOFR discounting (vs OIS) but there will be mapping exercises on how to obtain a credible history of the curve for VaR and SIMM/UMR use.

• Lastly, the more trivial, will we replace Fed Funds in the Sharpe calculations with SOFR?

The theory that re-papering sooner to alleviate basis risk concerns an easy aspect. The practical aspect suggests going this route alone could create more issues than absorbing the basis risk for a few months, especially as the costs of running this difference will be quite small for the short term, and smaller again with low rate volatility.

Option 2. We work together as an industry and move as a herd. There are two solutions 1) yell from the hills that we all push for this as soon as practically possible after October and pressure the counterparties as an industry, or 2) start advocating higher bodies for a coordinated ‘big-bang’ date to manage this bilateral switch, a solution that would potentially lead to an undesirably delayed switch date. The latter option also assumes that all participants want to re-paper to SOFR, where there may be funds that feel OIS is a better representation of their funding costs and adding SOFR discounting simply creates new basis risks.

October is an aggressive timeline. We need to speak up as an industry on what we would like now.