Information 'gaps' on derivatives clearinghouses' US Libor shift could lead to market volatility, regulator warns

27 Jul 2020 4:30 pm by Neil Roland

bank offices

US derivatives market participants lack adequate understanding of how a key step in the transition of clearinghouses to Libor’s successor is to work in October, risking market volatility, the head of the Federal Reserve-sponsored panel overseeing that transition said.

Tom Wipf, head of the panel, cited a US tabletop exercise showing information “gaps” among market participants about the timing and “dynamics” of a collateralized derivatives pricing move to the Secured Overnight Financing Rate at CME Clearing and LCH Ltd.

Lapses in the planned Oct. 16-19 shift “could be potentially disruptive to the pricing and liquidity of SOFR instruments, potentially leading to unanticipated volatility for the market overall,” Wipf told a Commodity Futures Trading Commission panel.

Wipf, head of the Alternative Reference Rates Committee, said a “lack of congruency” between the two clearinghouses “may create confusion or perceived advantages for certain market participants.”

Major differences between the clearinghouses’ plans “may create significant operational and market risk for participants,” said Wipf, also a Morgan Stanley vice chairman.

The CFTC advisory panel made recommendations for clearinghouses, banks, regulators, and hedge funds and other buy-side participants. These recommendations are to be considered by the full commission, headed by Heath Tarbert.

— Table-top exercise —

The October step for Chicago-based CME and London-based LCH is a stride in the derivative markets’ transition to market-based rates such as SOFR by the end of 2021, when regulators plan to stop guaranteeing the existence of tarnished Libor.

The tabletop exercise conducted by the CFTC panel covered the clearinghouses’ nearly synchronized plans for the transition to SOFR of “discounting” and “price alignment interest” for US dollar-denominated products.

The clearinghouses plan to drop the federal funds rate for calculating interest payments on collateral for the products, and replace the rate with SOFR.

To minimize the impact of the valuations change on users’ contracts, the clearinghouses plan to compensate participants with either cash or swaps.

Auctions of swaps are to be used to ease the provision of cash to participants who elect this form of compensation, and to determine how much cash will be given out.

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