2017-02-19

Change of benchmark overnight index is a difficult task: CHF case

In a blog published in September 2014, I claimed that a change of benchmark overnight index is a difficult task. A that time the claim was a reaction to US Federal Reserve and ISDA suggestions that changing the main USD overnight index from "Fed Fund effective" rates to a general collateral overnight index (DTCC GCF Repo Index) was easy. The reason behind that difficulty was described in that blog and, to my opinion, the misconception that it could be easy comes from a misunderstanding of what "OIS discounting" means. As you know, I'm not a fan of the terminology as it hides too many fundamental issues behind the mechanism (see Section 8.1 of my book on the multi-curve framework). People realized the difficulty of the process and in particular a US Treasury staff later commented that "Any transition away from a dominant benchmark will surely be complex and lengthy". That comment lead me to ask Did the US Treasury read my blog?

In the present blog, I will present similar arguments, but this time in relation to the proposed changed of the CHF reference overnight index. The proposed changed is described in a recent article in Risk magazine: Swiss rate reform set to trigger swap value change (subscription required).

The current main reference rate in CHF for overnight rates is the TOIS published by COSMEREX AG. The above sentence contains a contradiction on a contradictory term, as I wrote "overnight rate" and "TOIS" means "Tom/next rate used in Overnight Index Swaps", but I will ignore that detail here. The proposed replacement is the SARON ® (Swiss Average Rate OverNight) developed by the Swiss National Bank (SNB) and SIX Swiss Exchange. The SAR family of rates are based on CHF repo transactions. There are indices with tenors from ON and T/N up to 12 months.

The situation is very similar to the USD one that I analyzed a couple of years ago; some people estimate that the replacement of an unsecured overnight rate (or tom/next) rate by a secure rate based on transactions would be better.

As before, I certainly agree that using a secured rate as a reference rate for collateral remuneration would be a logical step. In the OTC derivative market, where Variation Margin (VM) will become mandatory in a couple of weeks (on 1 March 2017), having a good reference rate will certainly be more paramount than ever. The collateral posted for VM is done mainly in cash, and is equivalent in some sense to collateralised lending. The cash collateralises the derivatives as much as the derivatives collateralise the VM cash.

Is a secured rate better as a reference for the OIS in the OTC derivative market? That is entirely another question. The answer depends on what you want to use the derivative market for. Is it to hedge the interest rate risk of a book to align it to a secured or an unsecured borrowing? I'm sure there are plenty of situations where secured borrowing hedging will be the correct one and plenty of other situations where unsecured borrowing hedging will be the correct one. As much as I strongly prefer the secured rate as a reference for the collateral, as much I don't have a preference in the case of the reference rate for the derivative market. Or more exactly I believe the ideal solution would be to have a market for both, but if there is only one market I don't have an economical preference for either of them.

I don't have an economical preference, but I have a strong mathematical/quantitative finance simplicity preference; I would prefer to have the same rate for collateral and swap reference. That preference is strongly linked to the subject of the above mentioned Risk article and lies in the in depth understanding of what "OIS discounting" means. To my opinion, most of the article and the people interviewed for it got the foundation of OIS discounting wrong.

The goal is to reform the SARON definition and completely replace the TOIS index, including discontinuing it, for collateral remuneration and OIS reference by the end of 2017. To achieve that the following steps must be taken (this is a reworked list from my 2014 blog).
  1.  Create the reformed version of SARON.
  2.  Create a liquid OIS market linked to SARON.
  3.  Make sure that bilateral traded new OIS refers to a (new) CSA related to SARON collateral interest.
  4.  All dealer have to sign new CSA agreements for the new trades.
  5.  CCPs create a new category of trades with SARON collateral; it is not possible to net the existing trades and variation margin as the trades have different reference collateral rates and no full netting is possible. Cross margin for new and old indices are not possible. Or more exactly a payment netting is possible but not a netting of new and old instruments in term of positions.
  6. Run, up to the maturity of the longest trade existing in the world linked to TOIS, two parallel markets, one for the TOIS trades and one for the SARON related trades. This includes computing convexity adjustment between the different trades (good for me, more work for quants, see Theorem 8.11 in my book). The dual collateral rules require each user to run a double set of multi-curve framework with collateral, one with each collateral. In total, one can expect four OIS markets to run in parallel: TOIS swaps collateralised at TOIS (current market), TOIS swaps collateralised at SARON (target collateral with current liquid underlying), SARON swaps collateralised at OIS (target underlying with current collateral), and SARON swaps collateralised at SARON (target market). Obviously there would also be multiple Libor markets.
  7. As an alternative to 5/6, users with existing position could decide to cancel the existing trades. That would require each individual user to agree on the valuation of each position and agree to cancel it for that price. The cancellation could be replaced by an alternative move from one collateral to the other, but in the same way all the parties have to agree on the valuation (as an up-front fee or a fee over the life of the trade) impact of the transfer.
  8. Analyses if the changes of collateral rules or of reference index means that all CHF related trades should be considered as new trades. Due to the rules on mandatory margin the answer to this has a huge impact. It would mean that all trades on TOIS and all trade with a CSA referring to TOIS will fall in the category of trades for which the bilateral margin is mandatory. The mandatory margining does not only apply to completely new trades, but also to any amendment of a trade, even a change of reference ID is considered as a new trade.
  9. Discontinue TOIS publication.
The numbers above are not an order in which the steps need to happen; it is just a list of them. It is better if 1. happens before 9., but for the rest there are plenty of permutations possible, all of them with some kind of inconveniences.

Base on that list, I would like to point to a number of issues that seem misunderstood in the above Risk article.

Consensus: The article states that "The consensus is moving towards the view that no compensation payments will be made". That may be true, but it is irrelevant. The derivatives market is driven by the individual contracts signed by each party. The consensus opinion of the working group is irrelevant to those contract. Each party will need to review its rights and obligation in each contract (individual trades, CSA, CCP agreements, etc.) and see what is applicable to him; no working group, trade body or regulator can decide the fate of existing or forthcoming contracts. As mentioned in the article by an ISDA representative: "parties to make changes to their contracts on a bilateral basis". And, I'm sure you had guessed it, I'm not part of that "consensus opinion".

Risk-free rate proxy: The fact that the OIS rate is in some circumstances associated to a risk-free rate proxy is mentioned in the article. Again, that may be true but irrelevant. For actual fixing, we are not looking at a proxy, but at the actual term sheet, what is legally binding. For discounting of collateralised trade (and all of them will be collateralised from next month), the number of interest is the collateral remuneration rate in the collateral agreement and the risk management procedure of each market participant, not a theoretical risk-free rate.

Libor to OIS discounting: One quote in the article assimilates the change between TOIS and SARON to the change from the Libor to OIS discounting from 2007/2008. The situations are completely different and no parallel can be drawn between the two. The Libor v OIS discounting changes refer to a change in the internal valuation policy of some market participant due to a change of the market levels (change of spreads). The economics of the trades themselves or of their related CSA where not changed. There was no externally forced changes to the term sheets. For some people, the Libor v OIS discounting changes were only a general recognition of a practice that was already used internally by some traders.

Terminate TOIS swaps: "The Swiss working group suggests market participants either terminate existing swaps, or have their floating leg moved to Saron." The above proposal is obviously incomplete, there are many other possibilities, like creating a proxy TOIS, move to SARON + spread, modify the terms of the existing swaps to LIBOR, etc. But even if only the above two possibilities are envisaged, it leads to the "one (or more exactly many) million CHF question": At what price do you do that?

By year end: The article mentioned that some people expect to have all this finished by year end. At this stage, it appear that no trade based on SARON has been done, no ISDA definition exists (expected by end of Q1) and no clearing house has definitively announced it will clear those trades (some potential clearing is expected by year end).

New trades: That very important issue of modified trades considered as a new trades from a regulatory perspective is not even mentioned!

Conclusion: Some market participants still strongly misunderstand the OIS discounting concept, which is not a quant shiny toy but something ingrained in market trading and legal practice. Due to foundations, evolution and implementation of the market, changing any part of its functioning, even the reference overnight index of one currency, is a huge undertaking.

I strongly doubt it will be done in less than a year. To my knowledge, since the September 2014 burst of noise on the similar subject in USD, no real progress has been made. If a "consensus" is forced on the market over that period, I predict many years of legal litigation. I will report on the evolution of the question when I have more information. I already pin a 1st January 2018 blog with a status report.

As usual, my contact details are available in the Book details section of the blog. I'm happy to discuss those  issues with industry representatives, regulators, investors and journalists.

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