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Updated: ARRC Announces Recommendations for Voluntary Compensation for Swaptions Impacted by Clearinghouse (CCP) Discounting Transition to SOFR
Practical Law Legal Update w-025-6193 (Approx. 5 pages)
Updated: ARRC Announces Recommendations for Voluntary Compensation for Swaptions Impacted by Clearinghouse (CCP) Discounting Transition to SOFR
by Practical Law Finance
| Published on 22 Sep 2020 • USA (National/Federal) |
The Alternative Reference Rates Committee (ARRC) released its recommendations that a voluntary exchange of cash compensation take place between counterparties to cleared legacy swaptions referencing USD LIBOR, and that counterparties specify an agreed discount rate using the Secured Overnight Financing Rate (SOFR) for new cleared swaptions expiring after October 16, 2020.
On May 14, 2020 the Alternative Reference Rates Committee (ARRC) issued a press release to announce its recommendations (May 2020 recommendations) that:
- Counterparties specify an agreed discount rate using the Secured Overnight Financing Rate (SOFR) for new cleared swaptions expiring after October 16, 2020.
The recommendation of voluntary compensation is intended to resolve uncertainty associated with the transition from the use of the effective federal funds rate (EFFR) to the SOFR for discounting cleared derivatives.
On January 21, 2020, ARRC published a consultation (January 2020 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 EFFR to the SOFR that is expected to occur on October 16, 2020 (see Legal Update, ARRC Publishes Consultation on Swaptions Impacted by Clearinghouse (CCP) Transition to SOFR).
In making its May 2020 recommendation, the ARRC incorporated feedback received on its January 2020 consultation, which included responses from more than 30 sell-side and buy-side market participants, and the May 2020 recommendations include a summary of responses to the January 2020 consultation. The January 2020 consultation and the May 2020 recommendation apply only to USD-denominated contracts.
The May 2020 recommendation provides three specific ARRC recommendations:
Recommendation 1: legacy swaptions. Unless otherwise previously agreed to by swaption counterparties, and as soon as operationally feasible, on a portfolio basis, market participants would simultaneously:
- Voluntarily amend legacy USD swaptions expiring after October 16, 2020 to be brought in-scope for International Swaps and Derivatives Association (ISDA®) Supplement 64, and to specify SOFR as the agreed discount rate.
- Exchange compensation for the difference in the value of these swaptions between EFFR discounting and SOFR discounting.
The ARRC recommends that this only apply to swaptions traded prior to March 30, 2020, unless counterparties agree to an earlier cutoff date. The ARRC notes that nothing precludes counterparties from agreeing bilaterally to an earlier cut-off date.
Recommendation 2: legacy swaptions counterparty confirmation. The ARRC recommends that market participants contact their swaptions counterparties no later than June 30, 2020 to determine whether they intend to follow Recommendation 1. Prompt determination of this issue is recommended to:
- Avoid an extended period of uncertainty.
- Minimize valuation differences, as the current market-implied basis between EFFR and SOFR narrow.
- Promote responsible risk management and market liquidity and resiliency.
Recommendation 3: new swaptions. For new swaptions, the ARRC recommends that market participants specify at time of trade an agreed discount rate of:
- EFFR if the swaption expires on or prior to October 16th, 2020.
- SOFR if the swaption expires after October 16th, 2020.
In order to help market participants prepare for the change in central counterparty (CCP) clearinghouse LIBOR-SOFR discounting, on March 30, 2020, ISDA released a supplement (Supplement 64) to the 2006 ISDA Definitions (which govern most interest rate swaps) that allowed parties to specify an agreed discount rate in swaptions for which either cleared physical settlement or collateralized cash price cash settlement applies, and updated its collateral cash price matrix to specify:
- EFFR as the discount rate for a swaption that expires prior to the date (expected to be October 16, 2020) on which a global CCP switches discounting to SOFR, and
- SOFR after that date.
The primary affirmation platform for USD swaptions implemented these changes by adding a field for specification of the agreed discount rate.
The ARRC launched its January 2020 consultation following the announcements made in 2019 by the CME Group (CME) and LCH SwapClear (LCH) that they would transition to the use of SOFR for the discounting of USD-denominated interest rate swaps (see Legal Update, CME Updates SOFR Discounting Transition Plan with New Target Date of October 16, 2020). As with all ARRC recommendations, compliance with the May 2020 recommendations is strictly voluntary.
Update: On September 11, 2020, the ARRC added an additional recommendation regarding legacy swaptions to account for market participants that choose to forgo an exchange of compensation. ARRC suggests that if no agreement regarding the voluntary exchange of compensation has been reached by the counterparties before October 16, 2020, then the counterparties should amend their legacy swaptions to bring them into scope for ISDA Supplement 64 and specify an agreed discount rate consistent with the existing contractual terms.
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.