Change in discounting methodology at the clearing houses

The swap Central Counterparty Clearing (CCP) houses or Derivatives Clearing Organizations (DCOs) will be moving away from discounting utilizing the Effective Fed Funds rate to utilizing the Secured Overnight Financing Rate (SOFR) to value future cashflows and interest paid on collateral (PAI) for cleared swap trades.  This will happen in mid-October 2020. 

What does this mean for the market and for you?  The futures markets and swap markets for longer dated SOFR based swaps may become more liquid as Dealers will need to hedge themselves further out the curve.  The value of existing cleared swaps will change and you need to be aware that you will be compensated for the change differently at CME and LCH.  CME plans to utilize basis swaps to compensate for the valuation difference and LCH is planning to use cash payments to settle the differences.

Results of ISDA consultations

ISDA has conducted a series of consultations (request for opinions from the financial community) regarding LIBOR fallback language.  ISDA plans to have a protocol available by the end of the 1st quarter of 2020 which will modify the ISDA 2006 definitions for interest rate swaps to include fallback language in case of a LIBOR cessation.  

The consultation results in regards to pre-cessation trigger language did not provide a clear financial industry preference for a pre-cessation trigger and thus ISDA does not plan to include this language in the protocol.  ISDA received a letter from the Financial Stability Board strongly urging them to reconsider.  ISDA responded by stating that there will be a follow-up consultation regarding pre-cessation triggers and if there is a response to the consultation that this is desired, another protocol will be issued.  The protocols will only cover bilateral non-cleared trades.  ISDA has also said that some non-ISDA documents could be included such as Master Repurchase Agreements.

Federal Reserve consultation

The Federal Reserve has recently conducted their own consultation regarding the publishing of SOFR and backward looking SOFR averages.  While the results have not yet been published, the consultation indicated the Fed’s willingness to publish backward looking compounded SOFR averages for 30-, 90- and 180-days on their website.  By publishing these tenors, it is hoped that users of these rates would be able to more easily calculate interest rates for these periods and possibly it would be easier for older loan systems to accept a single rate than calculate the rate.  This could hasten the acceptance of SOFR that is being slowed by the amount of work needed to allow systems to accept SOFR in their interest calculations.

Financial Accounting Standards Board accounting relief

The Financial Accounting Standards Board (FASB) has ruled that the modification of existing hedging relationships, and of debt and other financial instruments due to reference rate reform will not constitute a new contract but rather the continuation of the existing contract or relationship.  FASB has stated that “the proposal would provide optional expedients and exceptions for applying generally accepted accounting principles to contracts, hedging relationships and other transactions affected by reference rate reform if certain criteria are met.”  Please speak with your auditors to understand how this will specifically apply to your own transactions.

Note: FHLB Cincinnati continues to respond to various industry consultations either individually or through System responses.  We strongly urge the membership to participate in the process and have your opinions on these issues be heard.