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IBOR transition: Anticipate NPV adjustments in the valuation of your derivative products

New reference rates have recently been introduced to replace the existing interbank offered rate (IBOR), which is scheduled to be discontinued in 2021.

Authors

Authors

Xavier Zaegel - [Sponsoring] Partner - Financial Industry Solutions - Deloitte

Fabian De Keyn - Director - Financial Industry Solutions - Deloitte

Jacques Netzer - Senior Consultant - Financial Industry Solutions - Deloitte

Published on 22 October 2020

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New reference rates (or new risk-free rates, “RFR”) have been introduced, aiming to replace the existing interbank offered rate (IBOR) benchmarks that are scheduled to be discontinued at the end of 2021. Major clearing houses have announced the adjustment of their discount curves previously calibrated on IBOR instruments to new benchmark rates (e.g., SOFR for US dollar-denominated derivatives and €STR for euro-denominated derivatives).

This switch, which began this summer for the LCH Group, Eurex Exchange and CME Group for euro-denominated instruments, will affect the valuation of cleared swaps and their respective marking-to-market mechanisms. Consequently, net present value (NPV) adjustments and resulting cash adjustments are expected for collateralized swaps. Alternatively, central counterparty clearing (CCP) houses will enable market participants to enter into overnight index swaps (OIS) and/or RFR-based swaps so they can keep a similar OIS risk exposure as previously held.

In the longer term, the financial industry is expected to use these new discount curves more broadly in the valuation of over-the-counter (OTC) derivatives.

Also, regulators are now urging market participants to proactively identify both cleared and noncleared contracts that require IBOR discontinuation fallback provisions to be added. Implementing these fallback provisions is also expected to affect the NPV of the contract, generating value transfers on the IBOR discontinuation day.

HOW IS THE NEW DISCOUNT CURVE CONSTRUCTED DIFFERENTLY?

Similar methodologies as the ones used to bootstrap old OIS curves still apply, including bootstrapping and calibration based on observed derivatives market prices. The main change in the determination of discount rates is in the set of instruments used for bootstrapping. OISs that reference €STR (resp. SOFR) rather than EONIA (resp. USD OIS) are now used for the short and medium end of the EUR (resp. USD). For longer terms, as the liquidity of associated OISs declines, futures or basis swaps referencing the new RFR will now prevail.

ILLUSTRATION EXAMPLE OF NPV ADJUSTMENTS FOR COLLATERALIZED SWAPS

We tested the impact of a discount curve switch from IBOR to the new benchmarks using different setups.

  1. We considered standard interest rate swaps respectively in USD and EUR currencies, namely quarterly USD Libor 3 months versus annual fixed, and semi-annual Euribor 6 months versus annual fixed.
  2. We considered swaps starting on 31 December 2019 for 10 different end dates, with fixed interest rates set at their respective par swap rates.
  3. We tested the impact of a discount curve switch on these swaps, valued as at 17 June 2020.

These tables illustrate the valuation differences of collateralized swaps when switching from the traditional OIS discount curves to the new ones, respectively for euro-denominated swaps (i.e., switch from EONIA discount curve to €STR discount curve) and US dollar-denominated swaps (i.e., switch from USD OIS discount curve to SOFR discount curve).

Both tables show that non-negligible NPV adjustments can be attained when switching from one curve to the other (up to 12 basis points for the EUR-denominated swap in Table 1).

Two key observations can be made regarding the impact of a discount curve switch on the swap NPV: (i) NPV adjustments tend to be larger when the expected future cash flows are large, especially if they are expected at long tenors; and (ii) NPV adjustments tend to be larger for long maturities.

Therefore, long-dated swaps (as forward rates may have deviated from their initial levels at inception, leading to potentially high future cash flows) especially those with long maturity periods could potentially have a high value transfer risk. Therefore, these should be identified as a priority and dealt with accordingly to mitigate the value transfer risk of a portfolio.

WHAT ABOUT DISCOUNTING NONCENTRALLY CLEARED DERIVATIVES?

With OIS curves currently at an industry standard for the valuation of collateralized OTC derivatives, at the moment there is no reason to believe that a curve other than the RFR would supplement the OIS after it is discontinued.

APART FROM THE DISCOUNTING EFFECT, HOW WILL THE VALUATION OF DERIVATIVES BE AFFECTED BY THE DISCONTINUATION OF IBOR RATES?

While the discontinuation of IBOR rates is scheduled for the end of 2021, regulators are encouraging market participants to actively transition contracts away from IBOR rates as soon as possible. Contracts referencing IBOR rates that terminate after this deadline (the so-called “legacy contracts”) should be carefully identified. Market players should ensure these contracts can either be converted to a non-IBOR rate or be amended to add clear fallback provisions regarding the discontinuation of the referenced rate. Legacy contracts that do not fall into one of these two categories are called “tough legacy contracts” and should be given special focus when implementing the transition, as uncertainty remains in how to deal with these contracts when IBOR is discontinued.

While most CCPs have already announced their intention to adopt the fallback provisions published by the International Swaps and Derivatives Association (ISDA) in their ISDA IBOR Fallback Protocol, regulators are urging market participants to identify their “tough legacy” exposures and proactively negotiate on a bilateral basis to amend or replace the exposed contracts.

As of today, even if the ISDA and local regulators have not yet adopted a definitive IBOR replacement option, ISDA consultations and working group publications on an IBOR replacement rate seem to favor a compounded setting in arrears rate, based on past observations of the RFR (over the corresponding IBOR rate term period) plus a fixed spread computed on the IBOR discontinuation day and based on a historical mean or median spread between the IBOR and the RFR rate (on a sufficiently long lookback period).

This replacement rate option, although fairly easy to implement, will most likely create value transfers among legacy contracts to net any valuation impact stemming from this fallback provision. Therefore, it is all the more important to clearly identify any exposed contracts in advance to properly mitigate this value transfer risk.

Conclusion

  • Although scheduled for the end of 2021, the discontinuation of IBOR rates has already started to affect the financial industry.
  • Transitioning away from IBOR rates will likely affect derivative counterparties from a valuation point of view, as methodologies and contractual terms are currently being updated to take the recently introduced rates into account.
  • Major CCP houses have already implemented a discount curve switch towards these new reference rates for the valuation of cleared swaps, affecting their marking-to-market mechanisms.
  • Regulators encourage financial industry players to proactively identify tough legacy contracts, which reference IBOR rates and terminate after the IBOR’s scheduled discontinuation date.
  • Counterparties are also encouraged to proactively negotiate on a bilateral basis to amend these exposed contracts.

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