LCH’s Transition from Fed Funds to SOFR Discounting in its SwapClear Service
LCH Risk Notice - SOFR Discounting
18 June 2020
All LCH Ltd SwapClear Members
IMPORTANT: This document aims to summarise certain matters relating to LCH’s transition from Fed Funds to SOFR discounting in its SwapClear service. It is provided for information only and is neither a full description of the LCH arrangements for that transition nor a recommendation or advice of any sort as to how the issues described may affect you. Accordingly, you may not rely upon the contents of this document. LCH Limited does not accept any liability in connection with its contents. SwapClear users are subject to the limitations of liability in the LCH rulebook. All readers should seek their own legal, financial or other advice, as appropriate.
As previously announced, as of October 2020 LCH intends to change the rate used in its SwapClear service for purposes of (i) discounting SwapClear Contracts, which are currently discounted using swap rates based on the effective federal funds rate (Fed Funds), and (ii) calculating Price Alignment Interest (PAI) and Price Alignment Amount (PAA) on cash collateral and payments denominated in U.S. Dollars, from Fed Funds to the Secured Overnight Financing Rate (SOFR). This change is referred to in this document as the Discounting Transition.
This change is required as part of the industry’s transition to risk free rates and has been developed to align with the Alternative Reference Rates Committee’s paced transition plan. The approach has been designed around broad market participant consultation and bilateral feedback and with ongoing regulatory engagement.
The Discounting Transition will result in a change in value (i.e. a portfolio that is currently discounted by reference to Fed Funds will experience gains or losses in value as a result of the Discounting Transition) and a discounting risk change (i.e. a portfolio that is currently discounted by reference to Fed Funds will, following the Discounting Transition, give rise to SOFR discounting risk instead of Fed Funds discounting risk). To mitigate these changes LCH has designed a compensation process which avoids unnecessary disruption, is as simple and straightforward as possible yet operates to a high level of accuracy, aims to provide coverage of risk mitigation where needed, with the flexibility to opt out of certain components if required. Taking all of this into account, LCH has determined the following:
(a) the Discounting Transition will apply to all new and existing in-scope SwapClear Contracts;
(b) in relation to the change in value caused by the Discounting Transition, LCH will provide a cash compensation mechanism; and
(c) in relation to the change in discounting risk caused by the Discounting Transition, LCH will (subject to certain exceptions described in Section 3.6 below) provide a discounting risk swap mechanism which is designed, to the extent practicable, to replicate the portfolio risk profile which existed prior to the Discounting Transition.
Capitalized terms used but not defined in this document have the meaning given to them in the LCH Rulebook, available: here. References herein to a SwapClear Contract include an FCM SwapClear Contract.
2. PURPOSE OF THIS DOCUMENT
The purpose of this document is to provide clients of clearing members with certain high-level information on how the compensation mechanism and the cash only election alternative (as described below in Section 3.5 below) will operate and some of the associated risks.
This document does not describe the commercial, legal or operational detail of the Discounting Transition nor does it identify comprehensively the associated risks for you. For further information on this, please refer to available materials on the transition at LCH (available: here, and which may be updated from time to time,) and discuss the transition with your clearing member and your professional advisors.
3. THE COMPENSATION MECHANISM
3.1 Value Compensation - USD
As more fully described in the materials referenced in Section 2 above (the Materials), in relation to all in-scope SwapClear Contracts other than those described in Section 3.2, LCH will determine, at the position-account level (i.e. in most cases, at the individual client level), an amount in U.S. Dollars, in favour of LCH or the clearing member holding that account that reflects the change in value of the SwapClear Contracts registered to such account as a result of the Discounting Transition. To the extent that a position-account has suffered a value “loss”, there will be an amount payable by LCH to that account, and to the extent that a position-account has a benefited from a value “gain”, there will be an amount payable by the relevant clearing member to LCH. The obligation to pay, or right to receive, that amount will be passed on by the clearing member to its client under the terms of industry standard client clearing documentation.
In order to calculate the amounts referred to above, LCH will compare the value of the relevant SwapClear Contracts where cash flows are discounted by reference to Fed Funds to such value when applying discounting by reference to SOFR, in each case as of “close of business” in New York on October 16, 2020 and using a ‘constant forwards’ methodology outlined more fully in public materials at https://www.lch.com/Services/swapclear/benchmark-reform. To perform the discounting by reference to SOFR, LCH will build a SOFR zero coupon yield curve using mid-prices from the auction process described below. The Fed Funds curve will be calculated using LCH’s existing methodology.
It is anticipated that the change in value will be calculated as of the end of day on October 16, 2020 and clearing members and clients will be bound to make (or receive) the relevant resulting payments. From an operational perspective, the amounts owed will be reflected in accounts at LCH by October 19, 2020. This timing applies to all cash amounts resulting from the Discounting Transition.
3.2 Value Compensation – MXN
In relation to TIIE interest rate swaps denominated in MXN, the change in value of the discounted future cash flows due to the change in the USD discounting input curve from Fed Funds to SOFR will be calculated in MXN in relation to such SwapClear Contracts.
3.3 Operational Reflection of Cash Amounts
For solely operational reasons, the obligation to pay, or right to receive, any cash amounts in connection with the transition, will be reflected, from an operational perspective, as a fee on a contract which LCH will book in the relevant accounts. There will be no amounts payable under such contracts, except for the one-way cash amount which shall be booked as an upfront fee. The same operational process applies in relation to the cash amounts arising from the separate transition from EONIA to €STR.
3.4 Discounting Risk Compensation
As more fully described in the Materials, the change in discounting risk caused by the Discounting Transition is addressed as follows:
(a) a number of days prior to the transition (anticipated to be October 14th, 2020), LCH will determine a portfolio of Fed Funds – SOFR basis swaps (achieved synthetically through a combination of Fed Funds – fixed and SOFR – fixed swaps) across six maturity buckets (2Y, 5Y, 10Y, 15Y, 20Y, 30Y) which, to the extent practicable, would replicate the discounting risk profile for each position account immediately following the Discounting Transition (the Discounting Risk Swaps) in respect of the in-scope SwapClear Contracts registered in the relevant position account as of the end of such day (anticipated to be October 14, 2020);
(b) each Discounting Risk Swap will be designed to have a zero net present value at the point of registration, with the spread determined by reference to the mid-price determined pursuant to the auction process; and
(c) these Discounting Risk Swaps will be registered in each position account that is not a Cash Only Client Account (see below) or a De Minimis Participant Account on the day on which the Discounting Transition is effected.
Please refer to section 3.5(c) for a summary of the position if the auction "fails".
3.5 The Cash Only Election
LCH will provide each clearing member with the right to elect, on behalf of each client position account it holds and the client for whom it is held, that such position account should not have any Discounting Risk Swaps registered in it. This is referred to as the Cash Only Client Election Notice. Clients who wish to make this election must contact their clearing member and ensure that the clearing member provides the election to LCH ahead of the cut-off date (which will be communicated separately). Clients cannot provide the election directly to LCH, although they can review any elections made on their behalf through the LCH portal. Note that the election will be required to be made well before the transition date and will become irrevocable prior to the auction; clients will therefore be exposed to the risk of changed circumstances. Only one election is permitted with respect to all SwapClear Contracts in a single position account. In the context of the SCM model, the client election is at the Individual Segregated Account level or the "position account" level within an Omnibus Segregated Account (though please note the comments in (d) below regarding the use of net Omnibus Segregated Accounts). In the context of the FCM Model, the client election is at the FCM Client Sub-Account level.
Clients may wish to note the following with respect to the Cash Only Client Election Notice:
(a) Liquidation Amounts
If your clearing member elects for your position account to be treated as a Cash Only Client Position Account, the Discounting Risk Swaps that would have been registered in that account will be liquidated in the auction process referred to below and a Cash Only Client Account Auction Adjustment representing the pro-rata (based on notional) share of any difference between the auction clearing price and the mid-price will be payable by your clearing member with respect to your position account and in turn will be payable by you to your clearing member. The size of the Cash Only Client Account Auction Adjustment will be limited by a pre-determined auction proceeds cap, which will be set and published by LCH prior to the auction (defined as the Bid Offer Limit in the LCH Rulebook). This cap is designed to prevent any client account from incurring unquantifiable costs. Note that this limitation applies only to costs incurred directly in the auction itself. It does not capture or limit any moves in market prices that may occur between the date an election is made and the date of the auction. If the auction produces a better price than the mid-price, the winning clearing member(s) will be required to pay the difference to the Cash Only Client accounts, again in proportion to the notional value of their compensating swaps.
It is not possible to know in advance whether the economic costs or benefits of liquidating the Discounting Risk Swaps via this auction process will be more or less than those associated with accepting the Discounting Risk Swaps and closing-out, selling, or otherwise managing the Discounting Risk Swaps in the relevant market. By liquidating the Discounting Risk Swaps, you will not be hedged for the change in discounting risk following the Discounting Transition and you will be exposed to any short-term price movements during or after the compensation process (which would otherwise be mitigated by the Discounting Risk Swaps).
LCH intends to publish an indicative auction portfolio in advance of the auction process but subsequent to the receipt of client elections. This will not disclose individual client positions or contracts. There may be market movements and trading activity resulting from this publication. The purpose of this information publication is to ensure that auction participants, and the broader market, are well prepared for the transition, allowing time for a process of price discovery to take place before the auction.
If you do not elect for a position account to be treated as a Cash Only Client Account, you may want or need later to liquidate the Discounting Risk Swaps in the relevant market, and LCH makes no assurance as to the value of such swaps and you should be aware that your ability to liquidate the swaps and the proceeds of such liquidation may be impacted by the auctions run by LCH as part of the Discounting Transition.
Each client will be bound by the elections made by a Clearing Member in respect of the relevant position account, subject to and in accordance with the LCH Rulebook.
(b) Inability by LCH to fully liquidate Discounting Risk Swaps
If, in relation to a Maturity Bucket, LCH is able to auction only a portion of the full notional amount of the Discounting Risk Swaps that are the subject of the auction for that Maturity Bucket, then LCH shall, notwithstanding any Cash Only Election Notices which have been delivered on your behalf, allocate the Non-Auctioned Swaps to the position account held by your clearing member on your behalf, pro rata to that position account’s share of the total notional amount of auctioned Discounting Risk Swaps for that Maturity Bucket. As stated above, LCH will not take into account any auction bids for a Maturity Bucket that are more than a predetermined and published number of basis points away from the mid-price for that Maturity Bucket (this limit will be set-out by LCH in due course).
(c) Auction "Failure"
If LCH receives no bids or all bids are outside of the applicable pre-determined range in relation to one or more of the Maturity Buckets then it shall determine that no further auctions shall take place and you shall have Discounting Risk Swaps registered in your position-account, notwithstanding any Cash Only Client Election Notices previously delivered on your behalf. If there are insufficient bids to establish a mid-price, the spread on the SOFR leg of each Discounting Risk Swap shall be determined by LCH using observable market data and in accordance with LCH’s usual processes. It will be your responsibility to manage or liquidate any such Discounting Risk Swaps following an auction failure (as to which, see 3.5(a) above) depending on your preference.
(d) Net Omnibus Segregated Accounts
If your positions are held by your clearing member in a net Omnibus Segregated Account (please contact your clearing member if you are not sure) and your clearing member does not submit a Cash Only Client Election Notice in relation to your position account, you may still be treated as a client who has submitted such a notice if another client with a position account within the same net omnibus segregated account submits a Cash Only Client Election Notice – i.e. if a clearing member submits a Cash Only Client Election Notice in relation to a single client within a net Omnibus Segregated Account, all clients in such an account will be treated the same and deemed to have made that election. If you have your positions recorded in a net Omnibus Segregated Account and do not want to be exposed to this risk, you should contact your clearing member and consider moving your positions to a different type of client account at LCH.
(f) Reliance on Clearing Member
You are dependent on your clearing member for a variety of roles within the Discounting Transition, and should note the following:
· Only your clearing member can make the Cash Only Client Election Notice on your behalf and you are therefore bound by their election; and
· Only a clearing member can bid in the auctions and therefore the amounts owed to, or by, you and LCH’s successful auctioning of Discounting Risk Swaps are dependent on the bids submitted by clearing members generally and the results of the auction will have an economic impact on the amounts payable to you, or by you, in relation to in-scope SwapClear Contracts (as further described in this notice).
3.6 The Compensation Rounding Convention and De Minimis Participant Accounts
A rounding convention is applied to the notional value of all Discounting Risk Swaps as follows: 2Y $5m, 5Y $2.5m, 10Y $1.25m and >10Y $500k. If, following application of this convention and for a given maturity bucket, the discounting risk associated with the position account held by your clearing member on your behalf rounds to zero then you will be considered by LCH to be a De Minimis Participant Account and you will not receive any Discounting Risk Swaps for that tenor. In these circumstances, you will not be obliged to pay, or have a right to receive, any Cash Only Client Account Auction Adjustment. You will only receive, or have to pay, cash value compensation as described in paragraphs 3.1 and 3.2.
3.7 The Auction
In order to liquidate the Discounting Risk Swaps of Cash Only Client Position Accounts and determine the mid-price used for quantifying the spread on the Discounting Risk Swaps and building the SOFR zero coupon yield curve, LCH shall run a series of auctions.
Clients should be aware that the following key features of the Discounting Transition are determined by the auction process:
(a) the spread on the SOFR leg of the Discounting Risk Swaps;
(b) the mid-price for purposes of constructing the SOFR zero coupon yield curve, which will determine the cash value compensation payable or receivable; and
(c) the quantum of any Cash Only Client Account Auction Adjustment.
A description of the auction process is beyond the scope of this document. LCH may take certain steps in relation to the running of the auctions (including postponing the auctions) and this could affect the timing of certain other steps in the Discounting Transition process.
Further information on the auction is available: here
Fed Funds discounting is used at LCH for USD LIBOR, USD Fed Funds and USD SOFR interest rate swaps; and USD CPI zero coupon inflation swaps. However, Fed Funds is also used in discounting for MXN swaps and non-deliverable swaps in 8 other currencies (KRW, CNY, INR, BRL, COP, CLP, THB, TWD).