In a consultation issued on February 7, 2020, the Alternative Reference Rates Committee (ARRC) seeks views on whether it should recommend a compensation methodology for swaptions referencing US dollar LIBOR that could be affected by the change, from the effective federal funds rate (EFER) to SOFR, in the interest rate used for discounting and price alignment interest (PAI) that is currently expected to occur for cleared derivatives at two central counterparty clearinghouses (CCPs) on October 16, 2020. 

The Issues

A swaption is an option to enter into a swap. A swaption may be physically settled (i.e., the parties have agreed that they will actually enter into the underlying swap upon exercise) or cash settled (i.e., a cash payment will be made upon exercise equal to some agreed measure of the value of the underlying swap). If physically settled, the resulting swap will in many instances be cleared (because, e.g., the terms of the swaption so provide, or the swap is subject to a CFTC clearing mandate and no exception applies).1 Cash settlement, under some methodologies, uses a present value computation that adopts the discounting rate employed by a CCP.

Certain CCPs have announced a compensation mechanism for cleared swaps in existence at the time of the transition, comprising cash compensation for the change in valuation and a risk exchange (in the form of a basis swap or possibly its cash equivalent). This specific mechanism, however, would not create any compensatory transfers between the parties to a swaption unless the swaption has been exercised into a cleared swap by the transition date.

According to the ARRC, some market participants have expressed concerns about the potential economic implications of the CCP discount rate transition and asked that a compensation mechanism be provided for swaptions not yet exercised at the time of the transition. These concerns include that the transition will introduce a basis risk for market participants that have risk-offsetting positions in swaptions and cleared swaps and that parties may not have analyzed the potential implications of the transition at the time they entered into swaptions that will be affected by the change.

The ARRC notes that commonly used swaption documentation does not include an adjustment mechanism for CCP discount rate changes and that, depending on the settlement convention chosen, a swaption could be unaffected or the parties, by choosing to reference a CCP, would have implicitly agreed to follow the CCP’s changes. The ARRC states that any recommendation would not change the legal obligations under swaption documentation and would be strictly voluntary.

The ARRC consultation attaches proposed amendments to the 2006 ISDA Definitions which, among other things, would allow parties to incorporate prospectively an optional new parameter, the “Agreed Discount Rate,” for swaptions with cleared physical settlement, such that if the prevailing CCP discount rate at exercise differs from the Agreed Discount Rate, the parties would be required to agree on compensation or, failing that, cash settle the swaption.

Consultation Questions

The consultation seeks views on:

  • Whether the ARRC should recommend that voluntary compensation be exchanged for legacy swaptions.
  • If so, which of certain specified options as to compensation timing (at expiry/exercise of each swaption or upon a one-time portfolio-level amendment) and cut-off trade date it should recommend or whether it should not issue a recommendation on these matters.
  • In relation to the proposed amendments to the ISDA definitions for new swaptions, whether the ARRC should recommend a default specification of the Agreed Discount Rate2 (which would govern if the parties have not specified otherwise) and, if so, which of certain specified defaults it should recommend.

The closing date for responses to the consultation is March 9, 2020.

1 See, e.g., 17 CFR 50.50 (end-user exception) or 77 Fed. Reg. 74284, 74316 (December 13, 2012)(CFTC clarifying that the clearing requirement does not apply to swaps resulting from the exercise of pre-compliance date swaptions). 

2 The consultation refers to the “discount curve,” which presumably means the new parameter under the proposed ISDA amendments, i.e., the Agreed Discount Rate.