Compensation (and lack thereof): swaptions, protocol and swaps
Today is February 29th. I couldn't resits publishing something, at least for the date!
Yesterday a new article related to rate transition hit Risk.Net. This time about the swaption compensation (subscription required). This is what I said about this compensation a week or so ago:
"Personally I don’t believe that a market-wide compensation will be found, for the same reason that I believe that ISDA fallback protocol will not be generalised. Those value transfers create winners and losers; losers will sign, winners will not. If I know that I would have to compensate you for some swaptions and I have no legal obligation to do so, why would I even discuss a mechanism to do so?"
The only argument for the compensation is some kind of peer pressure and credibility of the transition process. This roughly the summary of the Risk article.
Let me compare this with my recent favorite subject: Cost of signing the LIBOR fallback protocol.
In the swaption case, there is a fully functioning contract; it may not be exactly what some people subjectively expected when they sign the contract, but the contract is clear and fully operational. There is a discussion of compensating subjective loser that misunderstood what they were signing. This change of value is coming from a change of discounting, not a change of term sheet cash flows.
In the LIBOR fallbak case for bilateral swaps, there is a well defined contract also, but it is not operational — the current fallback process would not work properly in case of discontinuation. There is the proposal to change the contracts with a new fallback. The new contracts are clearly different from the original ones and all participants, including ISDA, agrees that there will be objective losers and objective winners. There is the official warning from regulators (FCA) that not signing the protocol, i.e. changing the contract without compensation, will lead to "serious questions from supervisors". How come that there is no discussion to compensate the objective losers? This change of value is coming from a change of term sheet cash flows, not mere discounting.
In the LIBOR fallback case for cleared swaps, there is a fully functioning contract but that contract indicates that one party, i.e. the CCPs, can do whatever they want — remember the "at its sole discretion" in LCH rule 1.8.12? That party has indicated that he will change the contracts to simplify its job and decrease its risk. There is a regulatory mandate to trade with those parties — mandatory clearing. Everybody agrees that there are (not to mention have been and will be) objective losers and objective winners from those changes. How come that there is no discussion about compensating the objective losers? This change of value is coming from a change of term sheet cash flows, not mere discounting.
In the CCP discounting big bang, there is a fully functioning market with cash collateral and rates that still exists (at least to December 2021 for EUR and without planned end for USD). There was a fully functional paced transition plan for the change of discounting proposed by ARRC in 2017. That paced transition has been betrayed by CCP. To solve the big bang issue, a cash compensation of the discounting based on highly illiquid market quotes is proposed, but also a "discounting risk compensation". The latter is not acceptable by all market participants which will be forced to take part in an auction with uncertain outcome. No compensation for the auction loses is proposed by the CCPs. Another impact of this is the uncertainty about swaption valuation. And we are back to four paragraphs above.
Why is there a discussion about compensation of the first issue, which does not objectively requires one, and no generalized market discussion about the other three?
I will discuss the second issue at the Interest Rate Reform Conference (a quant perspective) next week and the QuantSummit the week after.
Note added 2020-02-29: A simple way to solve the swaption issue is to cancel the CCP discounting big bang approach and come back to the initially planned paced transition. It is a reasonable way to solve the issue. The only problem will be that people that have traded swaptions on the basis of the discounting change may request compensation for the its cancellation!
Yesterday a new article related to rate transition hit Risk.Net. This time about the swaption compensation (subscription required). This is what I said about this compensation a week or so ago:
"Personally I don’t believe that a market-wide compensation will be found, for the same reason that I believe that ISDA fallback protocol will not be generalised. Those value transfers create winners and losers; losers will sign, winners will not. If I know that I would have to compensate you for some swaptions and I have no legal obligation to do so, why would I even discuss a mechanism to do so?"
The only argument for the compensation is some kind of peer pressure and credibility of the transition process. This roughly the summary of the Risk article.
Let me compare this with my recent favorite subject: Cost of signing the LIBOR fallback protocol.
In the swaption case, there is a fully functioning contract; it may not be exactly what some people subjectively expected when they sign the contract, but the contract is clear and fully operational. There is a discussion of compensating subjective loser that misunderstood what they were signing. This change of value is coming from a change of discounting, not a change of term sheet cash flows.
In the LIBOR fallbak case for bilateral swaps, there is a well defined contract also, but it is not operational — the current fallback process would not work properly in case of discontinuation. There is the proposal to change the contracts with a new fallback. The new contracts are clearly different from the original ones and all participants, including ISDA, agrees that there will be objective losers and objective winners. There is the official warning from regulators (FCA) that not signing the protocol, i.e. changing the contract without compensation, will lead to "serious questions from supervisors". How come that there is no discussion to compensate the objective losers? This change of value is coming from a change of term sheet cash flows, not mere discounting.
In the LIBOR fallback case for cleared swaps, there is a fully functioning contract but that contract indicates that one party, i.e. the CCPs, can do whatever they want — remember the "at its sole discretion" in LCH rule 1.8.12? That party has indicated that he will change the contracts to simplify its job and decrease its risk. There is a regulatory mandate to trade with those parties — mandatory clearing. Everybody agrees that there are (not to mention have been and will be) objective losers and objective winners from those changes. How come that there is no discussion about compensating the objective losers? This change of value is coming from a change of term sheet cash flows, not mere discounting.
In the CCP discounting big bang, there is a fully functioning market with cash collateral and rates that still exists (at least to December 2021 for EUR and without planned end for USD). There was a fully functional paced transition plan for the change of discounting proposed by ARRC in 2017. That paced transition has been betrayed by CCP. To solve the big bang issue, a cash compensation of the discounting based on highly illiquid market quotes is proposed, but also a "discounting risk compensation". The latter is not acceptable by all market participants which will be forced to take part in an auction with uncertain outcome. No compensation for the auction loses is proposed by the CCPs. Another impact of this is the uncertainty about swaption valuation. And we are back to four paragraphs above.
Why is there a discussion about compensation of the first issue, which does not objectively requires one, and no generalized market discussion about the other three?
I will discuss the second issue at the Interest Rate Reform Conference (a quant perspective) next week and the QuantSummit the week after.
Note added 2020-02-29: A simple way to solve the swaption issue is to cancel the CCP discounting big bang approach and come back to the initially planned paced transition. It is a reasonable way to solve the issue. The only problem will be that people that have traded swaptions on the basis of the discounting change may request compensation for the its cancellation!
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