26 November 2019
LIBOR transition: opening the buy-side liquidity pool
Vikash Rughani outlines a new approach to help buy- and sell-side participants optimise the transition of legacy LIBOR OTC swaps and other derivatives contracts to alternative reference rates
How are TriOptima’s optimisation services able to assist the market in the event of a discontinuation of the LIBOR benchmark?
With banks no longer compelled to support LIBOR beyond the end of 2021, the industry is focused on developing alternative benchmarks across the globe, with the US, UK, Europe, Switzerland and Japan leading the way. The next stage is facilitating trading in the new rates.
In the meantime, to help market participants mitigate risk in the transition of legacy LIBOR contracts, TriOptima operates a regular series of portfolio compression cycles bringing together 20 or more buy and sell-side participants to compress existing LIBOR trades, where the vast majority of trading remains for maturities beyond 2021. These compression cycles can also act as the nucleus of a liquidity pool that will be essential for delivering new conversion methodologies for migrating away from the LIBOR benchmark for OTC derivatives.
To bring this back to your question, we will be introducing our benchmark conversion functionality to offer a unique opportunity for new buy-side entities who may not have traditionally been involved in portfolio compression – hedge funds and asset managers with directional portfolios, for example to join our established network of compression participants in converting their remaining LIBOR transactions once compression opportunities in a given exercise have been exhausted. The addition of these new participants will be crucial to the success of benchmark conversion because they represent the cash flow and risk offset – crucial in maintaining the CCP’s cash flow neutrality. This is akin to a market participant needing to execute a new transaction that is equal and opposite to their original position in order to compress their position in the CCP. In multilateral services such as ours, it is the strength of the network that provides the mechanism for finding offsets that already exist as opposed to having to execute new transactions with liquidity providers.
Performing these benchmark conversion exercises iteratively over time means we can help the market achieve a mass conversion from legacy LIBOR risk, on contracts maturing beyond 2021, into alternative reference rates (ARRs).
Which OTC instruments are supported?
The new benchmark conversion functionality will initially be available in compression cycles that include plain vanilla fixed float interest rate swaps, basis swaps, OIS covering all ARRs, zero coupon swaps and FRAs. Further down the line on the bilateral side, in addition to these products, we also intend to include this functionality in cycles including cross-currency swaps reference LIBOR.
Benchmark conversion will be offered in all currencies as alternative RFR transition plans take effect. For now, we see momentum in US dollars, sterling, the euro, the Swiss franc and Japanese yen. We can expect the sterling market to be a leading indicator for conversion due to greater established Sonia liquidity when compared to the other alternative RFR’s. However, we continue to wait for the tipping point in longer-dated Sonia trading volume versus LIBOR.
What results can participants expect?
Based on simulations we have been able to run, with sensible risk-based tolerance levels, we may be able to help with achieving up to a 70% reduction in cleared GBP LIBOR gross notional through compression alone. Importantly, the simulations showed that we can help to remove up to half of the remaining 30% by enabling firms to optimise on reducing LIBOR gross notional beyond 2021 and utilising risk replacement trade functionality made available to us by the CCP’s.
How does the process work?
After firms register for a specific compression cycle, we receive their trade population in that currency from the CCP. Participants then confirm which trades to include by sending us the trades they are interested in including in the cycle. Through the same exercise we will suggest trades to either terminate, amend or replace using risk-replacement trades. The outcome is that each trade is either left untouched, terminated fully, or amended in some way, such as a change to the notional, the direction, the spread or the coupon. If none of these are suitable for maximising the objective for LIBOR reduction, the result would terminate the legacy LIBOR trade and replace it with a risk-replacement trade referencing the Alternative RFR. It is this latter step that facilitates the conversion of netted LIBOR positions.
All participants gain access to the same secure platform and risk-based constraints. The entire exercise is performed under each participant’s own valuations and risk sensitivities. These constraints are defined by each firm within their own of risk appetite levels. This combination means there’s no uncertainty when firms come to verifying the resulting compressions and risk-replacement trades in their own system for risk impacts.
How do you see the process evolving?
Given that some 85% of outstanding LIBOR gross notional exists in the cleared world, our initial focus will be on the clearing houses, aiming to tackle the biggest pool as early as possible and freeing up resources across the industry, to focus on the more complex bilateral cash positions as well as non-linear products like swaptions.
Initially, we will be offering benchmark conversion for cleared trades in LCH, CME and JSCC. However, we expect sterling conversion from LIBOR to Sonia could kick-off as early as Q2 2020, with USD conversion commencing once CCP’s transition to SOFR discounting and price discovery and liquidity improve. We would then expect conversion activity to take centre stage for the industry in 2021 and we’ll be ready to support the industry with their efforts.
How does this offering compare with other solutions available in the market?
There’s talk of auctions with the purpose of migration away from the LIBOR benchmark and we’re likely to see other solutions being offered by brokers on the execution side, but numerous challenges remain today. The market is yet to achieve sufficient comfort in pricing maturities greater than 5Y. Longer-dated risk exposure won’t simply appear overnight. It is natural for firms to trade at the short end to start with and the rest will depend on the building of momentum. The SOFR discounting change next year may help, but brokers will need to be able to quote reliably, spreads will need to tighten, and the market will need to work out how ARRs behave in different conditions compared to LIBOR. The market will also look for greater certainty and clarity from regulators on potential margin impacts of amending transactions or replacement, as well as from tax and accounting standards board with respect to treatment and hedging benefit provisions.
Instead, beyond our continued compression activity, we at TriOptima are embarking upon a 12-18 month period of education and onboarding for buy-side firms in readiness for a full-scale rollout of the service in 2021, or when the market indicates its desire to commence conversion. What’s unique to our solution is the liquidity pool and facilitating the conversion through compression in a measured way whilst participants maintain control of the risk effects conversion can give rise to.
Firms may need to consider what they want to do with their legacy LIBOR book. Are they prepared to rely on implementing LIBOR fall backs in the event of cessation or do they want to participate in a proactive conversion to alternative rates?
What do buy-side firms need to think about in preparing for benchmark conversion?
Firms may need to think about the process of adhering to triReduce’s legal documentation, the data submission requirements, the consumption of output data from TriOptima or even from the CCP, and how they will adapt throughout next year to ensure they are maximising their compression potential as well as readying themselves for the conversion component. Some firms will require additional technology development to support the process for benchmark conversion, so it’s important to start thinking about this now and build it into the budget for the coming year.
As a multilateral exercise, benchmark conversion will require an all-or-nothing acceptance. Participants will want to review the proposed results before providing their firm’s acceptance. Only once all parties accept the unwind proposal does it become legally binding and get processed by the CCP. This ensures that all participants take responsibility for their submission, including the accuracy of their valuations and risk data, in order to maintain the integrity of the exercise.