As references to Libor declines ahead of 2021 and the use of Risk Free Rates (RFRs) increases, derivatives will have to adapt. So in this blog I will look at the cross-currency swaps and the choices needed to move to RFRs.
Cross currency swaps can behave quite differently to single currency swaps and I will present a number of options for users in the future. The conventions of two currencies can sometimes cause differences in payment timing, rate fixing dates and notional exchange.
This blog looks at the various options and how they may become part of the RFR-based cross currency swaps.
The current cross currency markets
Cross currency markets have evolved to follow the interest rate conventions of the individual currencies with the added component of notional exchanges on the first and maturity dates of the swap.
For example, a GBP/USD cross-currency swap referencing Libor (showing a single leg, part way through the swap so the initial and final notional exchanges are not shown) would look like this:
As per the Libor conventions, the USD Libor sets 2 business days before the relevant period (T – 2) while the GBP Libor sets on the first day of the relevant period (T + 0). Market participants who have managed this mis-match for many years are quite familiar with this feature. This also occurs in many other currencies where the two interest rate legs set Libor (or IBOR) on different days.
Interest settlements are on the final day of the relevant period (TN).
Another feature of the cross-currency swap is the notional reset at the start of each period. The above diagram shows the notional reset dates for the following period to show how they align with the interest payments from this period.
Many cross currency swaps are dealt this way to reduce the impact of the cheapest-to-deliver collateral on the swap pricing. And how does this work?
The spot rate is set at TN – 2 and the notional is adjusted at TN with a payment in one currency to set the swap PV to zero. This means the cheapest to deliver calculation is only over that quarter and the impact of the forward valuations is minimal.
The red circle shows the day on which both the interest and notional settlements occur.
Although most dealer-dealer swaps are done with notional resets, it is more common for end-users who are using the cross-currency swap in a hedge accounting transaction to not reset the notional.
Cross currency swaps with RFRs
With the very likely cessation of Libor sometime after 2021, the cross-currency market like their single currency one, will move to RFRs to replace Libor and other IBORs.
The use of RFRs presents us with some interesting challenges and decisions. The final rate is not known until the end of the relevant period if the ‘compounded, settled in arrears’ methodology is used.
Each of the two currencies can often have a different payment lag defined for the single currency swap. For example, USD uses a 2 day lag while GBP employs a 0 day lag. (See OIS Swap Nuances).
This means that if you align the rate set dates for the GBP/USD cross-currency swap legs then the payment dates inherited from the single currency OIS swap definitions will not occur on the same date!
For a single leg (as shown above in the Libor-based version) the interest payments for the RFR look like this:
The red circles show the 2 different settlement dates for GBP and USD interest payments.
But market practice could set the payment dates to the date determined by the currency with the longest lag like this:
The GBP settlement (red arrow) has now been moved to TN + 2 to align with the USD payment and both settlements now occur on the same day (red circle).
The notional reset dates
Now we have successfully made sure that the interest payment dates are on the same day (2 days after the end of the relevant period; TN + 2) we now have to look at the notional reset payments.
The notional reset payment dates are on the first day of the relevant period for the Libor-based swap. This means they are now on a different day to the RFR-based interest payments.
The new spot rate is set 2 business days before each relevant period starts to align with FX market conventions. The actual reset occurs on the first day of the relevant period which is before the interest payments (usually 2 days later).
In this case, the payments cannot be netted (interest and notional) which can add additional payment dates and potentially credit issues.
The cross currency RFR swap now looks like this (after moving the notional reset to the next leg):
The two settlement date (red circles) are now on different days.
Potential ways to align payments
The interest and notional payments can be aligned but this does imply some changes to reset days.
1. Change the interest reset days
With the typical 2 day payment lag for compounded, in arrears interest payments the relevant period for the RFR resets could be moved 2 business days earlier so the actual interest payments occur on the last day of the relevant period.
This may be a solution but any single currency interest rate hedges would also need to be moved 2 days earlier to line up properly.
This can cause operational and trading issues.
2. Change the notional reset days.
The alternative is to reset the spot rate for the notional exchange on the first day of the relevant period rather than 2 days prior. In this case, the payments would align but, like the interest rate changes, this can create complex operational issues for some users.
Either option would solve the problem but both deviate from the current conventions in OIS trading or Libor-based cross currency swaps. This would make one-to-one matches for cross currency swaps across Libor and RFR impossible.
Summary
The inevitable transition from Libor to RFR based cross currency swaps will present a number of challenges including the alignment of payments.
These will have to be resolved soon to avoid confusion and potential re-booking of swaps once conventions are adopted by the market.
The convention in USD for using a reset cut-off would seem the most likely here. It permits the accrued interest calculation to be done on T_{n-2} and paid on T_n, and applying the same cut-off for both currencies would permit the structure to be simplified.
Given that the natural hedge for at least the USD leg is a USD OIS (i.e. USD SOFR in this instance), and that any existing ‘3m Libor’ USD IRS on the book would be essentially a 3m SOFR compounded and likely again with a reset cut-off to retain the payment schedule, this would allow the IR and XCCY trades to align neatly without disturbing most of the existing market structures.
An additional factor may be that in transitioning existing software and systems to use RFR+spread as a fixing, if the banks can trade in such a way that the cashflow structures are unchanged even if the floating rates need modification that will permit them to continue using legacy systems for risk and PnL at least in the near term.
It seems very unlikely that the interest payment would be divorced from the notional reset payment given that the IRS and FI structures will not have this mismatch.
The tradeoff will be that around month-end the particular structure of the swap can determine whether all the RFR compound values include or exclude the last fixing and any associated liquidity effects, which are pronounced on SOFR but recently invisible from EFFR. Perhaps traders will just forward date such trades into the following month or specify their roll schedule to avoid it.
Thanks for the comments.
Firstly, my intention is to raise these issues to encourage more debate before the actual standards are set for the cross currency swaps. Once the standards are set (and we have to agree standards so that market quotes are easy to use) then I believe the market will start to trade more frequently.
One other point is that there may be a difference between the Libor fallback arrangements (i.e. to SOFR and SONIA plus spreads) and the ‘clean’ SONIA/SOFR cross-currency markets as they develop. Although this may not be ideal we have to allow for this possibility.
The T_(n-2) idea is one of the options proposed for the fallbacks. Although, in my opinion, it helps solve the legacy problem, offsetting the rate fixes from the relevant period to achieve the alignment of the settlement could be operationally problematic when hedging in OIS markets that do not have this feature. I admit, this is not beyond the capacity of many firms but is it really a good idea for smaller firms or buy-side participants? I am not sure we have an answer to this question yet.
Your point about making the notional reset and interest payments on the same days is often mentioned by market participants and seems to have broad consensus. But the challenge is how to make this work and still maintain a clear connection to the separate currency OIS markets.
Lastly, the article is aimed towards the new, RFR-based cross-currency markets rather than the fallbacks. I expect there will be a difference between the legacy market and the new markets which will have to be managed.
And thanks for the comments; this is a good debate about the future cross-currency markets.
Is there any existing xccy trade on overnight rate (e.g. US Fed Fund vs EUR EONIA). That already pose the similar issues. Curious how they solve this problem.
The liquid market (i.e. transparent market) does not really include EFF versus Eonia as the markets still trade Libor/Euribor.
But we do have markets in EFF versus USD Libor where the problem does exist.
The purpose of this article is to raise the question: is it better to align the payments (and there are examples where this occurs in basis swaps) or accept the difference? Aligning is sometimes operationally easier especially for buy side firms but it will not directly offset the single currency OIS.
Either way, we need some form of standard.
Thanks for your reply, I agree that there is a difference between the discussion of the new and the transformation of the old. However, there is a key operational reality which seems to be at play: the markets are not shifting to RFR-based swaps proactively, either in CCBS or in IRS. What appears to be happening is that participants are relying on the transition arrangements to transform IBOR books to RFR books as and when the transition actually happens.
This is an understandable result; why be the first to move from a liquid market to an illiquid one, particularly if your risk and regulatory functions are going to see large IR exposures and demand they are hedged back in the liquid IBOR markets anyway. There are also still unknowns regarding how long the IBORs will last, and whether different currencies will transition at different times.
If we assume that the transition will happen when the market is pushed over the line(s) and not before, what structures will they be? If I trade a 20y CCBS today, what instrument is that for the latter 17+ years of it? I suspect that as a result, at least in the short term, the fallback structures which result from ISDA decisions (like reset cut-offs) will dominate as, again, the liquid structures.
Once we are in the new world perhaps the market will shift from these unusual structures to cleaner RFR-based ones, but by then they may have decided a daily-compounded structure paid daily in arrears simplifies the currently disparate instrument and margining structures in the interbank market.
For me the key question is what the fallen-back cross currency basis swap structure will be, either by intent or by accident of combining separate decisions on different benchmarks.