After December 31, 2021 the Financial Conduct Authority (“FCA”) will no longer compel banks to submit rates for the calculation of LIBOR, which may lead to a permanent cessation of this benchmark. Chatham will update clients on the following four topics related to the transition from LIBOR unfolding this year:
- ISDA IBOR Fallback Protocol (“Protocol”) likely released in H2 2020
- Accounting Standard Codification Topic 848 (ASC 848) Reference Rate Reform in early 2020
- Central counterparties (“CCP”) switch to discounting using the Secured Overnight Financing Rate (SOFR) on October 16, 2020
- Chatham initiatives to facilitate SOFR discounting and valuing derivatives indexed on SOFR
We understand that there is a lot of information and uncertainty about the transition away from LIBOR. Chatham will share updates and communicate with you when there is enough clarity around the proposed events. We encourage our clients to reach out to their relationship manager with questions or concerns.
The events and information contained within this bulletin are subject to change as official announcements and determinations have not been made.
ISDA IBOR Fallback Protocol
ISDA is updating its 2006 ISDA Definitions (the “Definitions”) to reflect what happens if LIBOR ceases to function as a benchmark rate, as well as to provide fallback rates. The current Definitions contain fallback language that describe a mathematical average of rates offered by “reference banks.” The amended Definitions will remove the current fallback, define the parameters of an index cessation event, and address fallbacks upon the occurrence of a temporary or permanent unavailability of a relevant rate. We expect amended Definitions to redefine USD-LIBOR-BBA from a rate determined by banks to a proposed spread-adjusted SOFR in the event of an index cessation. The expected changes will also redefine the fallback if LIBOR or SOFR become temporarily unavailable at any point. Last year, ISDA selected Bloomberg to provide the spread adjustments to the various LIBOR tenors. Bloomberg will be calculating spread adjustments based on the median of the historical difference between each LIBOR tenor and a daily compounded average of SOFR in arrears for the corresponding tenor. To be clear, the Bloomberg’s spread adjustments correspond to fixings of LIBOR for the calculations of payments and are not spread adjustments of the tenor of the derivatives for the purpose of a value transfer. If LIBOR ceases to exist and neither party to a derivative addresses the contract, then the spread-adjusted SOFR in the Definitions effectively becomes the value transfer.
In conjunction with the release of the amended Definitions, ISDA will also be publishing the IBOR Fallback Protocol. The Protocol will address which Definitions will govern existing trades. After the effective date of the Protocol, new trades that reference the Definitions will automatically incorporate the revised Definitions and these new trades will not require adherence to the Protocol or a similar bilateral amendment. We expect ISDA to release the revised Definitions and Protocol concurrently, with an effective date for each occurring between three and four months thereafter. ISDA also plans to make available language that accomplishes the fallback changes so that counterparties may amend contracts outside of officially adhering to the protocol.
It is also important to note that the Protocol changes will only impact non-centrally cleared derivatives because cleared derivatives are governed by a Central Counterparty’s (CCP) rule books. The two CCPs that Chatham’s clients face, LCH Group Holdings Ltd. (LCH) and CME Group (CME), will largely track ISDA’s methodology but the timing and certainty is not 100%.
Once ISDA releases the Protocol, we recommend our financial institution clients evaluate their hedging strategies and overall portfolio composition to determine whether or when they will adhere. Although it would be operationally ideal for all derivatives transactions to be governed by the Definitions, this may not be entirely feasible as differences may exist between cleared and uncleared trades. There will be more clarity in the coming months, but we encourage your institution to look at your derivatives portfolio from multiple angles.
The Protocol and Definitions were expected to be released this month. However, ISDA has received critical feedback from the Financial Stability Board, the FCA, and others regarding the lack of a pre-cessation trigger in the revised Definitions. On February 5, ISDA announced that they would be issuing a follow-on consultation in February. Therefore, the release of the Definitions and Protocol have been delayed, pending the results of the consultation. Depending on market consensus, the Definitions will either include a hardwired pre-cessation trigger that will implement fallbacks if LIBOR exists but is no longer representative of the market or the option to include those triggers into legacy and future ISDA agreements. The anticipated deadline for the release of the Definitions and Protocol is now in the second half of 2020.
ASC 848 “Reference Rate Reform”
Considering the FCA will no longer compel banks to submit to LIBOR at the end of 2021, the Financial Accounting Standards Board (FASB) has put forth a proposed accounting standard to facilitate contract modifications for hedge accounting relationships affected by the LIBOR transition. The FASB plans to issue this accounting standard in early 2020 and will provide optional exceptions and expedients so that hedge relationships will not be impacted when LIBOR ceases to exist. “Under the approved guidance, a change in the reference rate for a contract that meets certain criteria will be accounted for as a continuation of that contract rather than the creation of a new contract.” Visit fasb.org/referenceratereform to read the proposed standard.
The standard is expected to be effective upon issuance, but all of its provisions are expected to be optional and must be elected in order to be applied. The standard applies to non-derivative products as well and thus it is important to understand the impact of adopting.
From a hedge accounting perspective, even though the intent of this standard is to minimize the burden by the rate reform, clients with cash flow hedge accounting relationships under ASC 815 Derivatives and Hedging that extend past LIBOR expiring may be encouraged to elect certain portions of the standard shortly after issuance.
We are closely monitoring unfolding details surrounding ASC 848 as well as directly interacting with the FASB to gather more information and clarify its intent. We hope to soon be in a position where we can share more details and guidance.
SOFR Discounting by the CCPs
Both the CME Group and LCH have announced that they intend that to update their method of discounting transactions and calculating price alignment interest (PAI) to SOFR on October 16, 2020. Here are their respective announcements: CME announcement / LCH announcement.
By switching to SOFR from Effective Federal Funds Rate (Fed Funds) as a discounting method the value of each transaction will change thereby affecting your total exposure and total posted margin. The change in discounting methodology will only affect valuations while the underlying terms of the derivatives remain unchanged. As stated in the above links to the CME and LCH announcements, both CCPs are allowing counterparties the ability of settling the valuation difference via a cash transfer via Fed Funds to SOFR basis swaps.
PAI is the amount of interest that is charged on variation margin posted at the CCPs. The current rate of interest uses Fed Funds and will switch to SOFR upon the CCPs changing their rulebooks in October.
Please note that the discounting methodology changes being made by the CCPs will only impact their cleared transaction valuations and PAI. How the market follows the lead of the CCPs to valuations of bilateral trades, and then how the market eventually transitions to pricing in executing trades using SOFR discounting remains uncertain. From experience we have seen that the market took years before uniformly adopting Fed Funds discounting over LIBOR discounting.
As with the other matters covered in this bulletin, more will likely be developing this year on this topic and we will keep you informed with the developments and potential impacts.
How is Chatham preparing to handle SOFR-based discounting and the eventuality of valuing SOFR structures?
Chatham’s leadership team has commissioned a multidisciplinary team of directed and coordinated working groups who are actively defining the architecture and building the core infrastructure required to address the upcoming SOFR discounting change, valuing SOFR structures, and providing hedge accounting related to the market transition to SOFR. This team encompasses a sizable portion of Chatham’s forward-looking development budget in terms of staff and effort, including representatives across the following teams and organized groups:
- Executive leadership and project sponsorship
- Client advisory working groups: Financial Institutions, Real Estate, Corporates, Financial Services
- Regulatory advisory and advocacy working group
- Accounting advisory and advisory working group
- Quantitative research and development and models infrastructure development, including models risk management considerations
- Market data sourcing and market data quality control specialists
- Product development and product management teams who are focused on the deployment of SOFR capabilities across Chatham’s products and services provided to our clients
What are Chatham’s current capabilities?
Chatham stands ready to deliver solutions as key market decisions are finalized, the market for SOFR products develops, and clients choose to evaluate and eventually execute SOFR structures.
As evidence of early progress for SOFR support itself, Chatham released our constructed SOFR Forward Curve, based on published SOFR Futures market data in mid-2018. This work is foundational for valuing SOFR based structures.
If you have not already done so, we encourage you to visit the following resources related to our work constructing the SOFR forward curve:
Chatham clients may also access additional details behind our SOFR forward curve on ChathamDirect.com under the Benchmark Rates area of the platform. If you would like access to this module, please contact your relationship manager or FISupport@chathamfinancial.com for assistance.
Chatham also supports valuing SOFR swaps in an advisory capacity and as part of consulting with questions around balance sheet strategies. It is important to note that market liquidity is still relatively thin, and consequently market data is sparse, so valuations are currently suitable for purposes of conversation and rough comparison analysis activities.
Currently Chatham is actively building our own core model and product infrastructure to provide clients with appropriate solutions in the areas of:
- Valuing structures under discounting changes and for new indices
- Accounting considerations related to discounting changes and new indices
- Trade-level and portfolio-level exposure measures, for underwriting and managing portfolios of risk, with for structures with new indices
Chatham will communicate any meaningful updates throughout 2020 and beyond. Chatham clients should reach out to their relationship manager with questions or concerns.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal/notices/.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved. 20-0029