Libor Reform Changes IRD Trading

Basel Committee Consults on Interest-Rate Risk

The transformation of the interest-rate derivatives (IRD) market has been pushed into overdrive by several powerful trends, including Libor reform and clearinghouse innovation.

Cleared swaps performed, for the most part, in an orderly manner throughout the unprecedented transition away from Libor and during the massive volatility triggered by the start of the COVID-19 crisis in early 2020, and market participants are now looking forward.

“With the worst effects of the COVID-19 crisis and its impact on margins behind us, the transition away from Libor and the continued transition to clearing will drive market structure change in the coming years,” says Stephen Bruel, Senior Analyst for Coalition Greenwich Market Structure & Technology and author of OTC Interest-Rate Derivatives: An Evolving Market.

A Post-Libor Land Grab
Almost 70% of the U.S. and European interest-rate derivatives professionals participating in a recent Coalition Greenwich study say Libor-related reference rate reform has caused them to change the way they trade. The result has been a shift of volumes to alternative rates and the derivatives that track them. While 44% of respondents expect a one-for-one shift from Libor into a single alternative, there are competing replacements, especially in the U.S., and competition may shift liquidity over time.

“The market will certainly adopt recommended benchmarks like SOFR, but it is also looking to alternative rates that include credit sensitivity,” says Stephen Bruel. “Right now, it’s a global land grab for liquidity in the Libor replacement market.”

A Tailwind for Clearing

Roughly three-quarters of trading volume in the interest-rate market is cleared, a level that has increased only gradually over the past several years. However, regulation and subsequent costs are rendering bilateral swaps less attractive to trade, and the maturation of existing trades, uncleared margin rules (UMR) and the Libor transition all create a tailwind for clearing in the years ahead. Nearly 95% of study participants believe that they will move some bilateral OTC IRD volume to cleared OTC in the coming year. Twenty-five percent will use more futures as well.

As the buy side continues to shift volumes to clearing, central counterparty clearing houses (CCPs) must evolve in parallel. A majority of market participants believe the way to encourage the use of cleared swaps is to increase the range of clearable products. As Stephen Bruel notes, “The more a trader can clear through a single institution, the more they can benefit.”

The market is also looking to CCPs to invest in areas such as cross-currency product capabilities and margin optimization to entice flow from the buy side.

Source: Coalition Greenwich

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