The Changing Landscape of Interest Rate Swaps

We are currently in the throes of one of the biggest changes to ever affect the rates markets with the migration from interbank lending rate (IBOR) to risk-free rates (RFRs) benchmarks in order to price and value loans, bonds, derivatives, and a range of other financial products, such as interest rate swaps.

At the recent Tradeweb virtual event, ‘The Year Ahead In Derivatives Trading’, our expert panel discussed the changing interest rate swap (IRS) landscape across both the U.S. and European markets, the shift to alternative RFRs, and the most recent market structure updates. Our panel included Kari Hallgrimsson (Co-Head of EMEA Rates Trading, JPMorgan); Tracy Rucker-Wilson (Global Portfolio Risk Management Lead, Vanguard), Alan Farrell (Executive Director, Corporate Treasury, responsible for LIBOR transition, Goldman Sachs), Rosa Fenwick (Director, LDI Portfolio Manager, BMO Global Asset Management), and was moderated by Bhas Nalabothula (Head of European Institutional Rates, Tradeweb).

Transatlantic divide

From a purely UK perspective, we have reached the crux of a multi-year transformation of both assets and liquidity on LIBOR to SONIA, and the use of SONIA as an existing benchmark. Liquidity has been very good in SONIA for quite some time, thanks to the various initiatives such as ‘SONIA-First’ and forward-looking market participants willing to move into SONIA. Indeed, when looking at the liquidity of SONIA in terms of bid-offer spreads versus LIBOR in linear markets (switched over in October 2020), it is LIBOR that has been worsening in terms of liquidity. The non-linear derivatives market, whilst previously having faced difficulties in terms of liquidity, has recently seen a pickup in activity due to the ‘SONIA-First’ non-linear initiative of 11th May, as well as offering potential new benefits in terms of SONIA swaptions and LIBOR options opportunities. Meanwhile, exchange traded derivatives are due to switch over on 17th June 2021. This is expected to make SONIA futures more liquid than short Sterling.

In the U.S. on the other hand, market adoption of the Dollar LIBOR transition has been much slower than expected. There is still some market reluctance, which may either be due to questions as to how to shift from a credit sensitive index into a risk-free rate, or possibly non-possession of terms for the rate. Nevertheless, progress has been continuing, and an important catalyst has been the change in rates used by LCH and CME for discounting and Price Alignment Interest (PAI) calculations simply because of the risk-compensating element. While there is a long way to go to replace the liquidity that exists in the USD LIBOR market, there is hope this summer will see a sizable increase in volumes.

Because deadlines for cessation of publishing certain USD LIBOR settings will continue at a staggered rate until June 2023, there has been a lot of recent discussion around alternative rates. There are sections of the market, especially the cash market, that believe that the trading of RFRs do not necessarily meet the needs of the client, so there has instead been a push for credit sensitive rates. It is thought, however, that SOFR will be the area which will eventually gather the most liquidity and become the duration management instrument.

The year ahead: Milestones, catalysts & challenges

The period prior to the Sterling LIBOR transition deadline at the end of December 2021 will likely feel akin to a sprint finish due to the number of last-minute transitions that will be squeezed into those last few months. Firms with exposures that need to transition over the year-end can at least be comforted by the fact there are good fallbacks in place by signing up to the ISDA fallback protocols. Having an understanding of any structural risks within your portfolio that need to stay on the books post-year-end is a good way to start. Firms will need to also keep an eye on how the market is developing around the alternative non-SOFR products, as well as the Yen LIBOR market which has not at this point properly transitioned.

Whatever route firms decide to take, it is imperative that transitioning is handled in good time to avoid the rush for the excess, or run the risk of facing complications towards the end of this year. Organisations require plenty of time and a cross-functional team, both internally and externally, to ensure readiness to trade RFRs. Processes, the creation of OMS orders, and EMS parameters all need to work properly to ensure correct trading. Downstream, positions being held need to be correctly reflected in investment and account systems.

In short, in order to ensure success, organisations need to invest in the time necessary to properly test things out and not wait to leave things until the last minute.


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