The Alternative Reference Rates Committee ("ARRC") issued a consultation on whether it should recommend a compensation methodology for U.S. dollar LIBOR-referencing "swaptions" that are affected by a discounting change from Fed Funds to the Secured Overnight Financing Rate ("SOFR") for cleared swaps.
In a consultation, the ARRC responded to market participants' concerns regarding potential implications of the central counterparty ("CCP") switch to SOFR discounting (from Fed Funds Effective), starting on October 16, 2020. In relation to legacy interest rate swaptions, the ARRC consultation requests feedback as to whether it should make a recommendation regarding (i) the voluntary exchange of cash compensation between counterparties to legacy contracts and (ii) conventions for new swaptions entered into before October 16, 2020.
The ARRC noted, as to legacy swaptions that could be exercised after October 16, 2020, that market participants have expressed concern and asked for the CCP compensation mechanism to be expanded. In particular, the ARRC noted that market participants expressed concern that this creates a basis risk for persons using cleared swaps as a hedge for bilateral swaptions (or vice versa), and that market participants entering into swaptions may not have sufficiently accounted for the discounting change until recently.
For new swaptions (i.e., entered into prior to the October 16, 2020 transition date), the ARRC noted that market participants have requested greater clarity. The ARRC consultation highlighted several amendments that ISDA is considering making to the 2006 ISDA Definitions to address the changing cash discounting at CCPs. In particular, the ARRC requested feedback on whether it should make recommendations as to how those amendments address matters relating to the discount curve for swaptions.
Responses to the consultation are requested by no later than March 9, 2020. Unless anonymity is specifically requested, the ARRC indicated that comments will be posted publicly.
Commentary Nihal Patel
The ARRC consultation does a good job of laying out issues for swaptions presented by the CCP discounting switch. Persons active in the interest rate swaption market should closely review and consider responding to the consultation. (Particular questions on legacy swaptions can be found on page 8.)
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