ARRC Publishes Consultation on Swaptions Impacted by Clearinghouse (CCP) Transition to SOFR | Practical Law

ARRC Publishes Consultation on Swaptions Impacted by Clearinghouse (CCP) Transition to SOFR | Practical Law

The Alternative Reference Rates Committee (ARRC) launched a consultation seeking feedback from market participants on whether it should recommend a compensation methodology for swaptions referencing US LIBOR that could be affected by the discounting change for cleared derivatives from the effective federal funds rate (EFFR) to the Secured Overnight Financing Rate (SOFR) that is expected to occur on October 16, 2020.

ARRC Publishes Consultation on Swaptions Impacted by Clearinghouse (CCP) Transition to SOFR

by Practical Law Finance
Published on 19 Feb 2020 • USA (National/Federal)
The Alternative Reference Rates Committee (ARRC) launched a consultation seeking feedback from market participants on whether it should recommend a compensation methodology for swaptions referencing US LIBOR that could be affected by the discounting change for cleared derivatives from the effective federal funds rate (EFFR) to the Secured Overnight Financing Rate (SOFR) that is expected to occur on October 16, 2020.
On January 21, 2020, the Alternative Reference Rates Committee (ARRC) published a consultation seeking views from market participants on whether the ARRC should recommend a compensation methodology for swaptions referencing USD LIBOR that could be affected by the discounting change for cleared derivatives from the effective federal funds rate (EFFR) to the Secured Overnight Financing Rate (SOFR) that is expected to occur on October 16, 2020.
The consultation seeks feedback as to whether the ARRC should issue recommendations on:
  • The voluntary exchange of cash compensation between counterparties to legacy contracts.
  • Conventions for new swaptions traded before October 16, 2020.
Market participants may submit comments to the ARRC on the consultation through March 9, 2020.
The ARRC published a paced transition plan in 2017, which included specific steps and timelines meant to encourage the adoption of SOFR (see Practice Note, Interest Rate Benchmark Reform: Working Groups: Transition Timeline). Steps 4 and 5 of the paced transition plan called for central counterparty clearinghouses (CCPs) to:
  • Begin allowing market participants to choose between clearing new or modified swaptions into:
    • the current price alignment interest (PAI)/discounting environment; or
    • a PAI/discount environment that uses SOFR for PAI and discounting.
  • No longer accept new swap contracts for clearing using EFFR for PAI/discounting, except in limited circumstances.
In 2019, CCPs CME Group (CME) and LCH SwapClear (LCH) announced plans that would replace steps 4 and 5 of the ARRC paced transition plan and instead, effective October 16, 2020:
  • Use SOFR exclusively for PAI/discounting of new swap contracts going forward.
  • Modify outstanding swap contracts to replace EFFR with SOFR for PAI/discounting.
(See Legal Update, CME Updates SOFR Discounting Transition Plan with New Target Date of October 16, 2020.)
Both CCPs noted the potential issues surrounding the switch to SOFR discounting from EFF – specifically, in relation to swaptions not yet exercised by October 16, 2020, stating that such legacy swaptions would introduce "a basis risk for market participants using cleared swaps as a hedge for bilateral swaptions (or vice versa)." Furthermore, the CCPs stated that the parties "may not have analyzed or understood the potential implications of such a switch on their contracts when entering into them." The CCPs therefore asked that a compensation mechanism be provided for such swaptions.
For more information on LIBOR and interest rate benchmark reform, see LIBOR Replacement Toolkit.
"ISDA" is a registered trademark of the International Swaps and Derivatives Association, Inc. (ISDA). ISDA is not a sponsor of Practical Law and had no part in the development of this Update.