The Sunrise of SOFR: Derivatives Market to Face First LIBOR Transition Test in October

While the official transition from LIBOR (the London Inter-bank Offered Rate) to SOFR (the Secured Overnight Financing Rate) is expected for early 2022 (last mandatory publication of LIBOR is Dec 31), the derivatives market will face its first real test in October of 2020, when the Chicago Mercantile Exchange (CME) and London Clearing House (LCH) – the central counterparty clearing houses that clear the most of the derivatives relevant to the US Dollar market – make the transition to SOFR discounting. And while banks still have plenty of time to adapt, they need to start now in order to be ready to capture and process new trades when that happens.

While preparations for the transition are already well underway at most large global banks, many of those in the tier 2 and tier 3 categories have yet to take needed action.

Clearing houses are moving early to capture liquidity

As this transition date nears, clearing houses will be the first to impose a change, which will affect most banks trading US derivatives. In efforts to capture maximum liquidity, each clearing house wants to be the first to execute SOFR trades and encourage clients to make the transition sooner rather than later. After initially targeting a late summer 2020 date for transitioning to SOFR, the current consensus between the CME and LCH is October – but it could change between now and then, particularly given the current COVID-19 pandemic and resulting market conditions.

Provided the transition moves forward as planned, beginning in October, banks with swaps cleared against one of the central counterparty clearing houses (CCPs) will experience two immediate effects:

1. The PAI (Price Alignment Interest), and consequently the discounting index, will be changed to SOFR, generating a valuation change which will be compensated in cash in the margin accounts. In order to properly value the price of swaps, banks will need to be able to model that index, and even define already a blended curve switching from EFFR (Effective Fed Fund Rate) to SOFR forward on October 2020.
2. Banks will also automatically receive from CCP a strip of swaps that aims to compensate the basis risk between the former discounting rates (EFFR) and the new one (SOFR). If banks have not yet prepared their infrastructure to capture the new rate, they will not be able to value these basis swaps.

The sooner banks take action to prepare, the better

In order to prepare their derivatives trading infrastructure for the shift to SOFR, banks must adapt in a number of ways. First, they must update a series of systems in their front-to-back infrastructure to recognize SOFR index and capture new trades accordingly. These systems need to be able to manage trade schedules with daily fixings known in arrears. It particularly affects accounting systems, which will have to be enabled to post accruals and average rates on a daily basis.

Banks also need to prepare to manage a mismatch between the loans on their banking books and the swaps used to hedge them in the trading book (i.e. one could be migrated to SOFR before the other is). This will result in irregularities in hedge effectiveness reporting, and the need to monitor and reconfigure these pairings after migration is complete.

Banks will also need to navigate curve management by rethinking – and sometimes rebuilding – their analytical frameworks. Additionally, banks must update their procedures for calculating end-of-day risk using historical value-at-risk methodology, as historical data on SOFR is not existing and will need to be extrapolated.

The impact on the CCP transition has a far-reaching impact beyond cleared transactions themselves. For instance, there is an immediate impact on valuation of OTC swaptions delivering a cleared swap after the respective clearing house transition date. As CCP is not involved in that trade before swaption expiry, CCP doesn’t provide a compensation mechanism the same way as it does for their cleared swaps. Counterparties should include this fact already in their valuation, and potentially negotiate bilateral compensation no later than today.

These measures represent examples of the actions that banks need to take in order to prepare for the “sunrise of SOFR,” and are by no means an exhaustive list. But for those who have not yet begun the adaptation process of updating their derivatives infrastructure in earnest, October will be the first real test – and it is approaching fast.