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And in the run-up, banks and money managers that find themselves caught on the wrong side of trades are scrambling to limit their losses while their counterparts look to cement their gains.
Nowhere is this tension more evident than in the market for swaptions. That’s because pivoting to the new benchmark — known as the euro short-term rate, or ESTR — to help value hundreds of billions of euros of swaption contracts is set to trigger a sudden shift in prices, magnifying in many cases the gains and losses that traders will book.
While a European Central Bank-backed committee has suggested a framework for parties that profit from the change to reimburse those that lose out, it cannot force the market to adopt its methodology, leaving trading partners to iron out their own deals. In the U.S., financial firms are watching for clues ahead of a similar transition planned for October.
The upheaval is all part of the global move away from Libor and other discredited reference rates, which still underpin hundreds of trillions of dollars of assets, from mortgages in the U.S. to syndicated loans in Asia. Clearing houses, in coordination with regulators, are switching to alternative benchmarks in part to help bolster their liquidity.
For traders of centrally-cleared interest-rate swaps, their positions will be automatically adjusted. But because the majority of swaptions are bilateral, non-cleared contracts, they won’t be governed by mandatory compensation rules.
“There are real profit and loss issues,” Priya Misra, head of global rates strategy at TD Securities in New York, said via email. “Any investor who has a positive net present value position should benefit. Whoever is on the other side will lose.”
The ECB began phasing in ESTR in October, and the benchmark will fully replace Eonia, which is still linked to more than 100 trillion euros of financial instruments, in early 2022. Regulators prefer ESTR because of the more robust trading that underpins the benchmark, making it a truer reflection of the cost of capital and less susceptible to corruption.
Similar actions are underway in sterling and dollar markets after rigging scandals engulfed indexes that for many years were bedrocks for the global financial system.
In Europe, the largest banks are already in contact over compensation tied to their swaption portfolios, said Jan Rosam, a partner at Ernst & Young in Germany. He expects talks to drag on until at least the end of next year. The whole market is hoping to avoid a messy dispute, he said.
“Large banks and brokers will start first and then it will cascade down to the buy-side,” he said. “It’s nothing that will be done in a couple of weeks. We’re talking about amending thousands of legal agreements.”
Firms are watching how big U.S. lenders respond and there is uncertainty about what comes next, said an executive at one European bank, who asked not to be named given the sensitivity. If just one major counterparty refuses to cooperate then the voluntary system of compensation could collapse, the person said, adding that the most rational expectation is that nobody pays.
In the meantime, preparations for the benchmark change are accelerating. Fintech company Capitalab has already switched a notional 290 billion euros of its clients’ swaptions from Eonia to ESTR discounting, according to a source familiar with the matter who asked not to be named.
What Bloomberg Intelligence Says:
“Anything bilateral is open to negotiation — it’s strictly voluntary so let’s see how much cash compensation happens. Liquidity in ESTR products should increase as more hedging goes through.”
— Tanvir Sandhu, Chief Global Derivatives Strategist
The ECB declined to comment on the compensation recommendations from its working group except to say they are based on market consensus and lack legal standing.
Across the Atlantic, the U.S. faces similar rancor as the Secured Overnight Financing Rate, or SOFR, replaces the effective federal funds rate for discounting cash flows for dollar-based swaps. The Alternative Reference Rates Committee — convened by the Federal Reserve to guide the Libor transition — is recommending its own voluntary compensation arrangement ahead of the October shift.
Not everyone is panicking — hedge funds in particular are keeping a cool head. A portfolio manager at one of the largest macro funds in London said he hasn’t thought much about the problem but doesn’t believe there will be major impact.
The founder of another top fund said the switch won’t create any problems and the market is adapting seamlessly. Pricing around Eonia and ESTR suggests little opportunity for arbitrage, where traders exploit differences in value, he added.
The chief executive officer of a third fund said there could be winners and losers because many legacy swaptions were priced assuming the underlying swap would use the old discounting system.
Banks now face tough decisions. They could resort to ‘cherry picking,’ seeking compensation but refusing to budge where they owe money. Although this might be cost effective, larger institutions will be wary of reputational damage from a public row with their rivals. At the same time, lengthy haggling and identifying which instruments merit compensation may simply be too much to manage.
“Some firms may just say ‘it’s not feasible and we’ll do no compensation and not engage with any of the counterparties,’” said Suzanna Brunton, a managing associate at Linklaters LLP in Paris. “I don’t think that’s an unreasonable response.”
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