As LIBOR gets ready to end, SOFR is set to begin.
While the derivatives market had been changing fairly rapidly prior to COVID-19, 2020 market dynamics have not closed the gap between expected and observed market prices. It’s critical that corporations and institutions address the coming reference rate changes related to their derivatives and debt instruments tied to LIBOR.
The transition from LIBOR to SOFR consists of several pivot points and market changes. The International Swaps and Derivatives Association (ISDA) is updating its protocols to establish a new fallback reference rate provision for derivatives. The Chicago Mercantile Exchange (CME) is updating its clearing systems’ valuation methodology to use new discount curves for margin call valuations. In addition to the move away from the LIBOR reference rate, the SOFR market will change the way interest is accrued and how compounding will work.
Before COVID-19's financial sea-change, some participants observed signs that bond prices started reflecting LIBOR cessation. However, as the new 2020 market dynamics took prominence, attention shifted to managing current risk volatility vectors. It was expected that the LIBOR and SOFR markets would move in relatively similar ways; that has not been the case. Highlighting the market’s uncertainties are short-term market rate dislocations. Over the last year, SOFR and LIBOR rates have behaved very differently under times of stress (See Illustration), resulting in additional valuation uncertainty.
ISDA Changes for Derivatives
Expect ISDA to launch its amendments to the 2006 ISDA definitions and related protocol in early-mid October of 2020 as soon as it receives approval from the DOJ and similar foreign authorities. Changes to the protocol will occur following a two-week notice. The new ISDA protocol will remain open and effective for three months (through January 2021). Reference rate reform tied to derivatives should make most fallback provisions and the transition timing uniform.
CME Update for Cleared Swaps
Chicago mercantile exchange is planning to transition to a SOFR based valuation on 10/16/2020. This will amend the clearing systems' swap valuations methodology to discount all positions on a SOFR curve with updated margin calls based on new inputs. As the next LIBOR transition deadline looms, the market and practitioners have refocused on valuation and risk issues. With less than a quarter to go, the industry has failed to reflect the most extensive market structure change in valuations since ISDA's original Definitions in 2006.
CME has created a framework whereby the valuation change impact will be offset through equally valued basis swaps deposited to counterparty portfolios. Counterparties can choose to either hold these basis positions or liquidate them to meet additional margin requirements. This effectively standardizes derivative instruments with reference to the fallback language and inputs eliminating any valuation differences for the counterparty.
Valuation Differences Between LIBOR and SOFR
In addition to which reference rate and valuation curves will be used, there are also marked differences between how the LIBOR market and the SOFR market work.
LIBOR is set in advance and is a forward-looking rate curve where banks are willing to borrow at various terms. The LIBOR curve includes a bank centric credit risk premium.
In contrast, for derivatives, ISDA has announced that SOFR interest will compound daily in arrears for an interest period. Compounding in arrears requires a specific defined “look back” period with a lag between measurement date and payment date. SOFR is a secured, overnight, risk-free rate that will need to be adjusted for a credit risk premium. The Alternative Reference Rates Committee (AARC) has recommended using a historical median over a five-year lookback period that calculates the difference between LIBOR and the SOFR to calculate a standard credit spread over SOFR.
On the debt side, neither the timing nor the fallback language is expected to be as uniform as the derivatives markets. The lending market is hoping for a systemic solution to alleviate the fixed rate issuance valuation uncertainty, akin to the derivatives market's proposed ISDA protocols which aligns the valuation inputs and the transition timing for derivatives under ISDA.
Call To Action
Many valuation models are not ready for compounding in arrears with a flexible look back and lag days. This means that your models might not be able to calculate the proper accrued interest on your instruments since accrued interest is unknown until the end of the interest period. It is essential to ensure valuation system readiness. Hedge Trackers interest rate valuation models can accommodate all valuation nuances today and as they change.
Immediately evaluate derivative and credit exposure. Examine and identify fallback language and risks, renegotiating as necessary. If left unchanged your current fall back provisions could significantly increase interest expense for your organization. Private placements tied to LIBOR generally fallback to Prime, or worse. Expect to see significant valuation divergence and interest cost surprise should borrowers fail to amend any LIBOR referencing instruments in time.
Address hedge relationships. If fallback provisions on debt and derivatives differ, then the risk of a breakdown in the hedge relationship exists. While the FASB has made it clear that hedge accounting can continue under rate reform, it does not address the real economic risk of a rate mismatch in the hedge relationship.
Get exchange traded derivatives prepared for the October 16, 2020 CME protocol changes by making the cash vs. basis swap election.
Hedge Trackers stands ready to assist you and your company in making the proper preparations for reference rate reform. Time is running out to prepare. We can help you understand what needs to be done by when, and how to properly disclose your company’s adoption and risk mitigation from reference rate reform.