My advice on cash compensations in the IBOR transition
The new year brings with it new phases in the transition out of IBOR (InterBank Offered Rates). And the momentum is increasing. In 2020, there will be significant milestones in the transition, and for the first time, cash will begin to change hands.
The cash compensations will result from the switch to new collateral for derivative deals. In most cases, the compensation will result from contracts that are handled by clearing houses; in other cases, it will result from contracts that are between two organizations without a clearing house in the middle.
Clearing houses in Europe have announced their plans to make the rate transition from EONIA to €STR flat on June 22, 2020. The transition for US dollar-based collateral from EFFR (Effective Federal Funds Rate) to SOFR (Secured Overnight Financing Rate) will take place on October 17, 2020.
The collateral rate transition will trigger a change in the discounting, and that in turn triggers compensation for the change in discounting. Clearing houses will provide cash compensation payments for all accounts that had a euro-denominated position at the time of rate switch.
For the US dollar switch in October, in addition to the cash compensation, a basis swap EFFR/SOFR will be offered to retain the original risk position.
As someone who watches the IBOR transition closely, my advice to companies is to monitor how you are discounting swaps that are under collateral agreements because discounting is dependent on how collateral is bearing interest.
In addition, companies need to determine which of their contracts will be transitioned by clearing houses and which ones need to be transitioned bilaterally. I suggest aligning the rate used on contracts that are not related to clearing houses with the rate on contracts that will be transitioned by clearing houses.
Even if most of your organizations’ contracts will be managed by clearing houses, organizations need to plan the transition in full detail and manage their plan and associated risks.
Obviously, if the contracts were bilateral, the re-negotiation will require more effort, and you should be in talks now about making a smooth transition. As there will be only one netted compensation amount per counterparty, you will have to decide how cash compensations are linked to individual deals.
The risks are high: If your company doesn’t have a good plan and manage it well, you could get stuck with some charges and then end up with an operational problem. Or you could receive compensation but not know how to allocate it appropriately on your profit and loss statement. Even worse, if bilateral counterparties cannot agree, or if they have some improper valuations, companies can actually take a loss.
It is all very complex. In fact, mind boggling might be the better term.
And regulators seem to know it: They are urging market participants to speed up their efforts in the transition. As for the sterling authorities, they are even urging swap market participants to switch to SONIA as early as March 2 and stop LIBOR (London Inter-bank Offered Rate) lending by the third quarter of 2020. In 2021, all old IBOR rates must be replaced by the new rates.
So companies must make sure that imminent cash compensation payments are well-prepared.