2017-02-27

Change of benchmark overnight index is a difficult task: follow-up

In my previous blog, I discussed the attempt by the National Working Group on CHF Reference Interest Rates to modify the CHF overnight benchmark index. Since my blog has been published, the minutes of the WG meeting have been published on the Swiss National Bank (SNB) website. The minutes also include the list of participants to the group.

In one of the documents, an ISDA representative indicates that the guidance are "non-legally binding" and "could be used as a tool for bilaterally negotiating amendments to contracts". The core of the issue is in the "non-legally binding" and "bilateral" words, but they seem to be largely ignored in the guidance.

The issues related to the change of benchmark overnight index are of three types.
  1. Contract modification. There will be changes in a lot of contracts (OIS and CSA). That will require a bilateral agreement on each of them individually.
  2. Valuation. Changing the contracts has valuation impacts. The compensation of those impacts will need to be negotiated individually.
  3. Risk management. This should probably be the first items and has maybe not entered in the discussion yet. The original objective of derivatives contracts like swaps is risk management. For example it may be used to swap some specific risk profile into an overnight unsecured funding profile. There is no way this risk management objective can be maintained if no unsecured overnight index is maintained. It would be reasonable for end used to ask not only for the monetary compensation of the change of value of the derivative but also for the lost risk management service. A compensation for forcing the end user to bear the cost of risk between secured and unsecured funding would appear reasonable to me. Beyond legal agreement and valuation impacts, there is a fundamental risk management reason for the original framework. Is the new framework covering those risk management requirements? This is an open question.
Coming back to the minutes of the meeting, they contain, to my opinion, the same misunderstanding that were analysed my previous blog.

1. Termination or change of reference for existing trades. This requires the agreement of all parties, contract by contract. Given the current burden on legal and client relation resources in most banks and derivative users in relation to the changes in the regulatory landscape of the derivative market, I would be surprised if there are many resources available to start those discussions in the next months.

2. Rational for a compensation payment of zero. The rational presented in the document is inconsistent with the well documented and precise collateral discounting approach (see Chapter 8 in my multi-curve book) used by most market participants. The reference to a "risk-free rate" indicates a misunderstanding around clean collateral discounting.

The argument in the minutes that "as the SARON swap market does not exists, the determination of any non-zero compensation payment is nearly impossible", proves that the market is not ready for the change, not that no compensation is due.

The argument that compensation has not been applied in "similar situations" like "the change from single-curve valuation to muti-curve valuation", indicates that the situation is misunderstood - the situations are clearly not similar - and not that a precedent exists.

3. Internal risk approval. In the minutes, an appendix gives some argument for participants to obtain internal risk approval to start trading SARON swaps.

The first point of the proposal suggest to "start trading short maturities". It is fine for me to start prudently. But as a consequence, it means that generalized SARON discounting is impossible. To be able to have pricing of SARON cash collateralized derivatives based on market prices, you need a SARON OIS market up to the maturity of the longest traded derivative (not the longest SARON OIS). This part of the proposal invites to introduce the SARON OIS slowly, over a multi-year periods, and is incompatible with a big-bang in a short 10 months period.

The second point refers to VaR. It says that "Historical Volatility (HV) of the SARON fixing is below the HV of the TOIS fixing, which allows using the TOIS risk framework without understanding volatility". The first part of the sentence may be correct, but it applies to an index which is under review, in a very specific period of stress on the market due to central bank interventions. Moreover it applies to the index itself, not to the OIS rates associated to the index which do not exist yet. The OIS rates as risk factors is what would be important for HVaR. But what seems particularly surprising is the sentence second part. If all the OIS positions were stand alone, a lower volatility would (in a weak sense) lead to lower VaR. In a portfolio setting, a lower volatility of one component will lead to a different volatility of the portfolio; if the volatility of the portfolio is lower or higher will depend on the positions and the correlations between the risk factors. New positions on a new risk factor, the SARON OIS, will appear; at the start there will be natural basis positions. Does the working group suggest that a 0 VaR is a good proxy for the basis TOIS/SARON risk in a HVaR framework?

4. Regulation for margin on non-cleared derivatives. The new regulation impact on amending trades is not mentioned at all in the minutes. I refer you to item 8. in my previous blog. Don't underestimate this issue.



I have already written a blog scheduled to be published on the 1st January 2018. The blog is written as a couple of questions. Will the situations be closer to the one I predicted in the previous and this blog or closer to the expectation of the WG? To be continued!

Don't hesitate to let me know if any bookie is offering odds on the timing of the CHF overnight benchmark; I would probably put a fiver on one side. On which side? I let you guess!

My side for the bet is maybe more difficult to guess than you think at first sight. You know my opinion, but you don't know my current position on the bet and as a trader I'm more a market maker than a punter. I trade with my brain (and my own wallet), not my heart.

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