EXCLUSIVE: CME adjusts discounting transition date to keep SOFR big bang alive

cme lch

US central counterparty clearing (CCP) house CME has confirmed that it will adjust the date it intends to perform its discounting transition from Libor to the secured overnight financing rate (SOFR) in the cleared swaps market to October 16 2020. In realigning the date with London-based counterpart LCH, the move keeps the prospect of a "big bang" in the cleared swaps market alive.

In a client communication seen by Practice Insight last night eastern time, CME announced the alteration after extensive consultation with market participants and the Alternative Reference Rates Committee (ARRC) paced transition working group.

"By conducting a single-day transition, we intend to achieve this goal while mitigating any potential risks and ensuing valuation changes," read the communication.

Separate previously-issued announcements earlier this year suggested that the pair would switch three months apart.

Previous comments by the ARRC encouraged a coordinated approach, noting in May that “a big bang would help to accelerate the development of liquidity in SOFR-linked derivatives". Despite this, LCH opted for October 17 2020 as the day it would switch its US interest rate derivatives to the new curve, sometime after CME had announced July 17 2020.

"At the end of the day what we want is a market-based solution," said Sunil Cutinho, president at CME Group. "We are still in discussions with clients, consultations haven't ended. However, we recently completed our second round of extensive client feedback and are proposing a single-day transition date of October 16, 2020."

Cutinho added that CME continues to have discussions with clients, and that the group does not have any reservations about changing dates. "There is nothing competitive in a date. This is a client-focused organisation and we want to ensure there are no disruptions for our clients. They have been very consistent with us."

"Clients are looking for a single date when all USD swaps can be converted to discount using SOFR. Our goal has been to work with our clients to achieve a single date where at least from a cleared swaps perspective we could do that, and will do our bit to help in achieving that," he said.

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Philip Whitehurst, head of service development for LCH's rates business, said that the terminology the CCPs use is "single step", rather than "big bang" – but the sentiment is the same. "We have consulted on a number of occasions with our user community, both members and clients, concluding that consensus among our users was also for that 'single step'," he said.

LCH issued some preliminary findings earlier in the year, and again in late July. The report focused on the importance of a single step, and also set the date of October 17. "We intend to deploy a compensation process that handles the valuation change through cash exchanges and the risk sensitivity change via basis swaps. We working now on the finer details," said Whitehurst.

"We are not at all hung up about October for its own sake, but we are hearing from customers that they are comfortable with the date and they are not particularly comfortable with going any sooner,” he added. "If we hear a change in that consensus, we can look again at moving it.”

CME's clients had initially felt that an earlier date was superior for multiple reasons. Firstly, the end of the next year is crowded with a number of events such as the uncleared margin rules' mandate phase five, for one, not to mention the US elections in November.

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Liquidity

Consensus suggests that it is clearly to the benefit of the industry to have a consistent date, but the opinion is not uniform. The head of fixed income at the US branch of a global bank suggests that it is a chicken and egg situation for the cleared swaps sector and other products.

"Trying to envision a scenario where Libor, the primary liquidity provider and the primary source of dollar swap liquidity, goes away and then with one big bang the market goes to SOFR, is difficult," he said.

"We don't think that is the best way for the market to transition, but it could happen. We have taken the approach that we need to get ready, but there are others who are being a little bit more laissez-faire and waiting for liquidity to develop before acting. We could see a situation where the market transitions relatively rapidly, and we want to see that happen.”

However, simply on the basis of operational consistency, systems being modified at the same time in the same way will result in the market dealing with the sudden change in liquidity across the CCP spectrum and into SOFR.

"It is better to just do it consistently – two tranches gives you too many issues. There are also some interesting arbitrage opportunities that probably don't make any sense from a systemic point of view," said Adam Schneider, partner at Oliver Wyman.

"Any number of institutions I talk to are looking for ways to simplify and de-risk. The consistent thread is that they all want it all to be on the same day regardless of which date is picked. To get liquidity in the SOFR world is very difficult. And if you want to be in the business of issuing cash loans and hedges, or borrowing and hedging, you need liquidity," he said.

"A lot of the product efforts are critically dependent on the evolution of liquidity in the markets and this is the last giant leap to get liquidity," he continued. "Our recommendation is to pull it out right now, despite the technical and operational issues. Liquidity needs time and systems that can trade."

David Horner, head of risk, SwapClear, said that the push for readiness is driving clients. Firms have got to encorporate new compliance regimes, which will increase SOFR based risk. "At the moment, as it stands, we have a relatively small proportion of customers who actively trade SOFR swaps. At the point of the conversion, everybody who is clearing any USD swaps at LCH will have exposure to SOFR discounting risk," he said. "That’s why everybody needs to be ready."

"From what we have picked up from customers, it is likely to be the same team handling both transitions. You can look at the efficiencies that may come from having one tech implementation and it can face these two quite important cleared counterparties. However, looking at the best way to coordinate this, the total bandwidth of these teams to run both processes at the same time has to be taken into consideration," said Horner.

See also: Special report: plugging the gap with SOFR