Get ready for RFRs: Preparing for the LIBOR transition in the derivatives market

This article was originally published in Traders Magazine, and can be viewed here.

The LIBOR transition for vanilla products may be straightforward, but the road ahead for complex derivatives will be challenging.

• There are additional challenges that participants in the derivatives market must bear in mind, centered around market data, pricing models and risk and position management
• This article presents viable solutions to these challenges

With the 2021 sunset of LIBOR looming on the horizon, the clock is ticking for banks and derivatives market participants to prepare for the transition to risk-free rates (RFRs). Most of the discussion around this transition focuses on linear products such as loans and swaps–but the industry has largely ignored how more complex transactions will be addressed, and that is a conversation that needs to occur.

Indeed, following the LIBOR transition, the $250 billion option and structured products market will continue to be benchmarked to LIBOR.

The derivatives market will face its first real test soon: in October of 2020, the Chicago Mercantile Exchange (CME) and London Clearing House (LCH), the central counterparty clearing houses that clear the most derivatives relevant to the U.S. market, will make the transition to SOFR.

For market participants, the process of transitioning from LIBOR to the new RFRs involves a high degree of complexity, a number of uncertainties, and substantial costs. Banks are aware of the implications and are acting now to renegotiate their contracts, update their systems, build new models, and manage risk accordingly.

Impact on options and structured derivative contracts and markets

It’s important to note that while the upcoming LIBOR sundown means that LIBOR might stop being published, it will not necessarily stop being traded immediately. Long-term trading contracts that continue to rely on LIBOR include interest rate swaps and options, floating-rate notes, forward rate agreements, and currency swaps. Due to pressure from regulators, market participants will increasingly move to new indexes. However, there has not been a unified call to action among the various regulatory bodies.

The reality is that the options market, in particular, is a complex product and has not transitioned at all. Structured products are still referencing the old indexes with disclaimers to explain that the LIBOR transition may require a change of benchmark in the future.

For the large volume of derivatives governed by the International Swaps and Derivatives Association (ISDA), the fallback index suggested for USD is the Secured Overnight Financing Rate (SOFR). For contracts under ISDA, where all parties are in agreement with the recommended protocol, fallback provisions should be relatively standard. Credit Support Annexes (CSAs) entered into with counterparties will have to be renegotiated and updated. The ISDA fall-backs, when they appear, will likely only cover fairly straightforward agreements. However, for more complex products, this will involve legal teams to draft new terms and client relationship managers to navigate the changes with their customers.

The most frequently traded products in question are caps, floors and range accruals. The structures require a forward-looking rate, typically Libor. However, the overnight rates set to replace Libor are only available in backward-looking compounded versions. Linking caps and floors to a rate that is compounded in arrears converts the product into something more complex. Payout is now based on an average of a series of spot values, rather than a single spot rate at a future point.

The change in the nature of the product means it contains different risks as before, and therefore can’t work as a hedge in the same way. For example, products that could previously be used to hedge European options – such as Eurodollar options – could no longer do so. Eurodollar options are based on Libor, which means a hedging mismatch with the new caps and floors.

“Term risk-free rates make sense as a solution to these problems but the viability of that solution rests on a very liquid underlying RFR swap market, which is yet to be fully the case for certain RFRs,”

Term versions of the new replacement rates are in development but are not due for release until later this year – and may take even longer to appear, due to delays caused by the coronavirus pandemic. Creating term risk-free rates requires liquid swap markets, which are not yet mature enough in some countries.

In addition, financial contracts based on certain indexes are more liquid than others, so other financial contracts trade as a basis to them. The 3-month LIBOR has always been the most liquid interest rate swap in the U.S., so 1-month LIBOR and 6-month LIBOR interest rate swaps traded as a basis to the 3-month LIBOR. As SOFR swaps begin trading as a basis to the 3-month LIBOR, they will become more liquid, and LIBOR will then trade off a basis to SOFR.

Over time, the trading volume of SOFR swaps will increase, and LIBOR swaps will become less common–and more illiquid. This shift could happen fairly quickly, or it might take years. Central banks are hoping that futures markets for RFRs will emerge that will facilitate the calculation of forward rates, but so far liquidity is looking too thin to create reliable benchmarks.

Challenges market participants must anticipate

Navigating the transition from LIBOR to SOFR and other RFRs presents a number of challenges to banks, particularly when it comes to complex derivative products:

• Market data: For products that rely on market data to inform trades, but for which there is not yet sufficient liquidity in the market, banks will need to use existing data for proxies. Banks must use the data that is available to them to project what a liquid product will look like and what conventions the market may adopt.
• Pricing models: The long history of LIBOR provides analytics to inform banks’ pricing models for products. Banks need to determine whether and how to shift pricing models, such as the LIBOR Market Model (LMM), to apply to the new RFRs. For example, in the case of new rates based on overnight compounding (such as SOFR), as opposed to a term rate, what new pricing models will need to be implemented?
• Risk and position management: During the LIBOR transition period, banks will have to manage heterogeneous portfolios. There is no straightforward way to swap options risk, making it far less straightforward than linear instruments. Basis swaps exist, but basis options do not. Risk managers will need to manage these portfolios very closely and carefully, being mindful of how consolidating their books and managing the transition will affect their risk profiles and P&Ls.

Action items to prepare for the shift to RFRs

In order to navigate the LIBOR transition for their existing complex derivative contracts, banks and traders will need to forecast LIBOR and SOFR index curves and generate discount curves for their contracts, using either SOFR or the federal funds rate for discounting. Their systems must be able to generate all those curves, as well as offer the flexibility to move to different curves as decisions are made, fallbacks are clarified, and markets evolve. The sooner banks can build these curves, value their portfolios, and take risk management measures accordingly, the better they will be able to support downstream systems.

In addition, trading desks must incorporate the new RFRs and instruments based on those rates into all systems in their value chains: from front-office trading to risk management to back-office trade processing and collateral management. The impact of switching to RFRs will have to be analyzed and modeled, and appropriate hedges put into place. This will have to take place on two levels. First, the direct change in valuation and risk profile of the swaps portfolios, but also the effect of changing the rates used for discounting swaps and price alignment interest (PAI) at clearinghouses. Both CME and LCH have announced that they will move from the Effective Fed Funds rate to the new RFR SOFR in October 2020 for PAI. This will create changes in the valuation of swaps positions, the interest accrued, and the necessary margin posted.

Finally, the migration from LIBOR will involve substantial operational and technology costs, which banks must anticipate and account for accordingly. Industry-wide, spending to prepare for the end of LIBOR will exceed $8 billion. Individually, major financial institutions should expect to spend $100 million across all lines of business. Finastra estimates a major bank’s repapering cost at $7,800,000, and a systems and operations cost of $9,300,000.

The transition from LIBOR to SOFR and other RFRs will not happen instantly with the flip of a switch. Rather, banks must prepare now to navigate a transition process that will affect products ranging from simple mortgages to complex derivatives contracts. By looking beyond the sunset date, anticipating market challenges, updating systems accordingly, and preparing to manage the cost, banks can position themselves for a smooth transition to a post-LIBOR marketplace.

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