Called the "Big Bang", it has derivatives traders on high alert.
In a critical development in the global shift from old benchmarks sparked by Libor's flaws, interest rate swaps on more than $ 80 trillion in notional debt will switch to a new interest rate this weekend to determine their value.
While the move to the overnight secured funding rate [SOFR] is expected to increase longer-term liquidity in the new benchmark, it also raises concerns about recalcitrant price movements as it is intended to trigger sales of double-digit billion dollar swaps.
"The Big Bang is one of the most important steps in the Libor transition," said Marcus Burnett, director of SOFR Academy, an education technology company whose clients include banks and money managers. "We expect the interest desks of the largest banks in New York to participate."
The reset, where SOFR will replace the effective federal funds rate in value swap calculations, is part of a push to make SOFR a standard US benchmark interest rate in the debt and derivatives markets. SOFR is set to replace the dollar Libor, which still underpins hundreds of trillion dollars in assets such as mortgages in the US and syndicated loans in Asia. The Big Bang follows a smaller pivot in Europe in July, a less complicated switch that came with little impact on the market.
With interest rate swaps, two parties can exchange one payment flow for another over a specified period of time. The most common variant, known as a vanilla swap, is to swap payments at a fixed rate for payments at an adjustable rate based on Libor or another reference rate. Another type, known as a base swap, has two adjustable interest rates.
While SOFR has struggled to gain ground since its inception in 2018, analysts say the impending Big Bang has already triggered a shift towards more trading in SOFR-linked swaps.
This could help pave the way for a curve that will reflect expectations for the future interest rate and address one of the main weaknesses in the new benchmark.
The Big Bang "will be very, very good for liquidity," said Jason Granet, chief Libor Transition Officer at Goldman Sachs Group Inc.
However, there will be turbulence in pricing in the near future. Clearinghouses plan to effectively neutralize the changes in swap values caused by the Big Bang, and traders will see their positions automatically adjusted. LCH Ltd. and CME Group Inc. are preparing to distribute compensation from customers who increase exposure to those who decrease.
LCH will facilitate the payment of hundreds of millions of dollars in cash to cover losses in value and at least ten billion dollars in basic swaps to offset risk, said David Horner, head of risk at SwapClear, which is part of LCH.
However, some companies do not use base swaps to hedge their discount rate risk or are otherwise unable to keep them on their books and are expected to sell them. LCH will hold auctions this Friday, allowing 18 banks to enter into unsolicited base swaps valued at $ 25 billion.
Buyers would ideally pick them up either as a hedge against risk or for their own worth. The approach is largely untested, however, as no basic swaps were distributed in the European version of the Big Bang.
"For about six months now, our members and customers have been able to view their screens with a forecast of the compensation payments and compensation swaps they will receive so they know what is going to happen," said Horner. "It is important for the market that it runs smoothly."
CME will hold a similar auction on Monday. Clients have agreed to a maximum loss, said Sunil Cutinho, President of CME Clearing, and "if their positions cannot be auctioned, they are fully protected and can use their own private funds to dispose of their positions."
However, there is concern about price volatility in the market amid a surge in supply as some banks forego basic swaps that they received in exchange.
The big question is how well the auctions are going. Clearinghouses do not guarantee the minimum prices for the base swaps, which could drop below the maximum the company is willing to tolerate, said Joshua Younger, strategist at JPMorgan Chase & Co.
"A lot of them would then probably unwind in the open market and the price movement could become very disorderly," he said.
Companies need to understand first that this change exposes them to higher risk before ultimately taking less risk, said Pieter Van Vredenburch, principal at Market Alpha Advisors and previously a member of the Alternative Reference Rate Committee responsible for the transition to the US Libor directs. when he worked for HSBC Holdings Plc in 2016.
"The big banks are very prepared for the Big Bang," said Van Vredenburch. "But I think the smaller banks are ready for that? Not even nearby." When it comes to switching to SOFR, he said, "The transition has so many nuances and the devil is in the details. There is nothing simple in any of this."