LCH SwapClear on the countdown to the big switch from LIBOR to SOFR
Tranche 1 executed successfully
With the transition to SOFR approaching the final stages into the end date of June 30th, Total Derivatives spoke to Phil Whitehurst, LCH Head of Service Development, Rates about LCH SwapClear’s Tranche 1 and Tranche 2 cleared swaps conversions from LIBOR to SOFR.
The Tranche 1 conversion took place on April 20th weekend. It contained VNS aka amortizers and zero coupon swaps. The conversion “was executed successfully, so we are really pleased with the outcome,” Whitehurst says.
“Tranche 1 dealt with ~10% of the total book, and with a couple of the more complex product types and therefore tested the full suite of conversion capabilities,” he adds.
Tranche 2 much larger; Preparations
Ahead, May 20th weekend is the Tranche 2 conversion for all vanilla IRS and basis swaps. Across the two tranches LCH expects there to be $45trn of swaps, and “a more important metric is that Tranche involves 600k contracts” while Tranche 1 has dealt with “just over 50k contracts,” Whitehurst emphasizes.
Tranche 2 is “largely a functional repeat, with a focus on the increased volume,” he explains. For comparison, the conversion for GBP LIBOR to SONIA in 2021 involved 200k contracts – thus USD Tranche 2 is 2-3x the volume.
As far as the timing, Whitehurst notes that ”LCH runs compression cycles intraday on weekdays and the clearinghouse can cope with bulk events involving ten of thousands of trades, but the weekend is better for even larger exercises such as these conversions.”
In preparation for the conversions, LCH has done two dress rehearsals “involving 300 to 400k contacts and those went well,” according to Whitehurst. “With the passage of Tranche 1 we picked up limited incremental learnings as you would hope. The key changes – and there weren’t many - had already been discovered through the dress rehearsals,” he says.
In addition, LCH provided members with a detailed schedule of the conversion process and have had regular communications going into this process. Consequently LCH is ““confident that the non-functional as well as the functional needs for members have been met. LCH members have exhibited strong engagement throughout this process and it is credit to them that the first tranche went smoothly.”
Still, not everything is a read across from the GBP LIBOR conversion. “One difference for the coming Tranche 2 conversion versus the non-USD conversions back in 2021, is that basis swaps were not split out. This was based on customer feedback. Some wanted splitting while others did not, so we resolved this by providing the tools for each firm to choose,” Whitehurst explains.
LIBOR swaps past the conversion date; Compensation
Whitehurst says LCH is providing capability to submit LIBOR swaps “after the conversion date both up to the cessation date of LIBOR and even beyond.” This can arise, for example, from the need to clear a LIBOR swap associated with the physical settlement of a swaption exercise. “While these trades are a very small percentage of cleared swaps, it is still non-zero. For example in GBP it was around 0.1% of contracts in the immediate aftermath of cessation,” he says.
In terms of compensation, Whitehurst explains LCH compensates the difference between the fallback profile (which is sometimes characterized as an observation period shift) versus the market standard (which involves no shift and instead uses a payment lag). Members have been receiving daily reports about the PV impact of the conversion on a trade level since December. He adds “the differences that emerge from the conversion for initial margin are minimal, since LIBOR risk is in essence already SOFR risk.”
Mindful of market volatility; Cautious but optimistic
As for the possibility of market swings around the key weekends, Whitehurst says “We take account of the potential for market volatility around the conversion dates, and for Tranche 1 we judged that the market was stable enough to proceed. We will look again at conditions going into Tranche 2.”
As opposed to tougher legacy LIBOR trades such as loan and securitizations and even options, converting cleared swaps is arguably much more straightforward. Indeed, Whitehurst notes that for market participants, the process of conversion of cleared swaps is “probably amongst the simpler instruments for the transition from LIBOR to SOFR. We can apply standardized processes across the board, which is a great advantage of clearing.”
“Overall, going into Tranche 2, the success of Tranche 1 builds confidence, but we aren’t taking the success of Tranche 1 for granted. We are keeping our focus for the Tranche 2 conversion, and are doing everything we can for that to go smoothly,” Whitehurst says.
And there is more to come. Next year around this time CAD CDOR will convert over to CAD CORRA. And, at some very uncertain point in the future, regulators will provide the push required for EURIBOR to give way to €STR.