EONIA/€STR – The Discounting Switch – a minor delay due to Covid-19
As part of the global benchmark reform the central objective of which is to make interest rate indices more robust, the ECB set the transition spread from EONIA to the new overnight rate €STR at 8½ bp back in October 2019. The working group on euro-risk-free rates encourages “market participants to transition … from EONIA to €STR flat, whereby the present value … will be calculated and exchanged as an upfront compensation to be agreed bilaterally.”
The discounting switch by central counterparties (CCPs) initially planned for mid-June this year has finally been completed. For the EUR-zone this cutover date was the 24 July 2020. The relevant CCPs (LCH and Eurex) have started using the new €STR for discounting future cashflows and calculating interest payments on collateral (PAI).
On Monday, 27 July 2020 the deltas in NPV for relevant transactions were communicated to their clearing members using EOD values from the preceding Friday. Any difference will be handled as a one-off cash compensation by / to the CCP. The recalculation was a relatively easy exercise as the transition spread of 8 ½ bp had been fixed and was therefore deterministic.
Note that this shift in portfolio values is only due to the effects of discounting. Other adjustments to valuations which will be caused by a new calculation methodology for the variable reference rates (RFR) and cash flows themselves will become effective soon, once the exact calculation methodology has been set in stone by the ECB.
Of particular interest is the size of the NPV deltas caused by the discounting switch. They are strictly negative for single out of the money trades from a bank’s perspective in which case a cash payment is made from the bank to the CCP. The amount exchanged is mainly a function of the notional and the tenor of the trades in a portfolio. I have analysed some of our clients’ portfolios. The following graph shows the relative distributions of NPV deltas.
Source: own analysis
As can be seen from the above graph, there was an NPV adjustment for 19% of the trades which was more than 23 bp but less than 31 bp of total NPV. This analysed portfolio showed a median of 14.3 bp and a mean of 15.4 bp. The net payment made to the CCP was about 450k EUR in this example.
By contrast a more complex exercise looms for transactions denominated in USD. The transition from the Effective Federal Funds Rate (EFFR) to its risk-free equivalent, the Secured Overnight Financing Rate (SOFR), is not based upon a fixed spread as it is the case for the €STR as explained above. The EFFR-SOFR-transition spread remains stochastic with a volatile trend around zero. It will not be until 16 October 2020 when the CME & LCH determine the respective spread following a lookback approach. From that point in time onwards the CCPs will use SOFR for discounting USD denominated transactions. Given the ongoing stochasticity of the EFFR-SOFR-transition spread even after 16 October 2020, counterparties face an additional risk: accounting risk.
In order to mitigate this type of additional risk, CCPs offer their clearing members two options:
(1) having their transactions auctioned and entering into an accounting risk swap with another counterparty or
(2) accepting a one-off compensation payment determined by the CCP.
Whether an institution opts for the accounting swap or the cash settlement will largely depend on its preferences, the sophistication of its risk management systems as well as its hedge accounting policies.
So far I have only considered the new O/N rate €STR and centrally cleared trades via a CCP. There are additional issues such as the transition to new term rates (RFR) or the bilateral treatment of contracts including bilateral CSA. Why is this of interest? Certain bilaterally negotiated CSAs contain a so-called Eonia floor. This gives one counterparty the right to receive 0% on its collateral posted to the other counterparty instead of paying the O/N rate that is currently negative.1 These contractual stipulations are equivalent to a call on the O/N rate struck at 0% and such deeply in the money options are therefore highly valuable.
In summary with the discounting switch the IBOR transition has made an important step towards enhanced market awareness and liquidity in traded instruments.
My takeaway points in a nutshell:
- market participants that are adopting a ‘wait and see position’ with respect to contract management and reduction to Euribor exposures might be running out of time once the cessation draws nearer;
- bilateral documents should be looked at in detail to avoid giving up a favourable contract without a fair compensation; and
- banks should also actively consider product optimisation potential coupled with enhanced client outreach as the next IBOR transition steps.
1 47bps negative at the time of writing