Interest rate derivatives referring to certain alternative reference rates should be subject to the clearing obligation in Switzerland by the beginning of 2023.

In short

• The revised FMIO-FINMA with a new scope of the clearing mandate is expected to be adopted in the third quarter of 2022, with entry into force expected in early 2023
• Changes to the clearing obligation will incur a cost for system changes, control framework changes, documentation and training
• To reduce these costs, it is important to have sufficient notice and to start adapting early so that you are not forced to adopt tactical solutions to meet short deadlines.

The Swiss Financial Markets Authority (FINMA) plans to amend the FINMA Ordinance on Financial Market Infrastructure (OIMF-FINMA) to update the list of interest rate derivatives subject to the clearing (Art. 101 Financial Market Infrastructure Act or FMIA), namely, which must be cleared by a central counterparty authorized or recognized by FINMA. A consultation is open until July 5, 2022 and the revised FMIO-FINMA should be adopted in the third quarter of 2022, with entry into force expected in early 2023.

New interest rate derivatives subject to the clearing obligation under the FMIA

The list of interest rate derivatives subject to the clearing obligation can be found in table I, appendix 1, point 1 of the FMIO-FINMA1 and should be amended as follows:

It should be noted that like CHF LIBOR, the SARON-linked derivatives to which the market switched from the end of 2021 are still not offered to be subject to the clearing obligation under the FMIA being given the relatively low transaction volumes.

Reason for change and context of global markets

Some of the interest rate derivatives previously declared subject to the clearing obligation by FINMA refer to benchmarks that have not been published or available for further use since December 31, 2021 (e.g. GBP LIBOR, JPY LIBOR , USD LIBOR, EONIA) due to their transition to more robust Alternative Reference Rates (ARR) (e.g. SONIA, TONAR, SOFR, €STR). While the most popular USD LIBOR maturities are still published until the end of June 2023 for use in legacy transactions (before 2022), the reduction in USD LIBOR swap trading activity due to the “SOFR First” market and “No new LIBOR” events could reduce the liquidity of these swaps prior to the final cessation of USD LIBOR. With regard to other IBORs for which the clearing mandate has been declared previously, such as NIBOR (Norwegian Crown), STIBOR (Swedish Crown) and WIBOR (Polish Zloty), it is also proposed to remove them from the clearing mandate. Although there is currently no termination date for the latter, by removing a wider range of IBORs from the clearing obligation, FINMA is taking a forward-looking view and reducing the potential for market disruption if the any of these IBORs will permanently cease to exist in the future.

Therefore, on the one hand, the clearing obligation for the types of transactions concerned is no longer supported by market volumes. On the other hand, there is currently no clearing requirement for interest rate derivatives linked to new ARRs to which liquidity has shifted since early 2022, resulting in a regulatory vacuum that could lead to lower clearing volumes and therefore potentially at higher systemic risks. .

The market needs global compliance with mandatory clearing. Similar changes are taking place in the financial centers important for Switzerland (EU, United Kingdom, United States).

There have been two approaches to the netting mandate for swaps referencing ARR by global regulators: (i) a netting mandate at the time of conversion from LIBOR to ARR; or (ii) a clearing mandate at a later effective date. In Europe, ESMA had removed LIBOR2 from the clearing obligation before recently adding ARR3 swaps.

FINMA opted for the simultaneous abolition of LIBOR clearing and the implementation of ARR clearing, while providing sufficient notice to allow market participants to adapt.

In essence, the amendments proposed by FINMA will be in line with foreign legal developments and will restore the original synchronization with the corresponding European regulation (i.e. the European Market Infrastructure Regulation).

Market feedback

Clearing is one of the main pillars of derivatives regulatory reform given its benefits for derivatives business, such as risk reduction through multilateral clearing, strict operational processes and ultimately , the reduction of counterparty risk. Additionally, other onerous regulations incentivize centralized clearing, such as uncleared margin requirements. This is evidenced by the compensation rates for new ARR products even though they did not fall within the scope of the compensation obligation and were already voluntarily compensated by market players in very large proportions. According to the Commodity Futures Trading Commission (CFTC) consultation on the same subject: “Reviewing swap transaction data from January 2021 to October 2021, the Commission staff was estimate that over 90% of the volume of fixed-to-floating swaps refering USD SOFR , GBP SONIA, CHF SARON, JPY TONA and EUR €STR were cleared on a voluntary basis. »4

For USD interest rate swaps that have not yet fully transitioned from USD LIBOR to SOFR (the transition deadline is end of June 2023), it is essential that there is sufficient liquidity in SOFR before supporting an offset obligation in order to avoid detrimental impacts on the market. Conversion of LIBOR swaps by central counterparties should provide the required liquidity in ARR swaps. The conversion date for JPY LIBOR was December 6, 2021 and GBP LIBOR was December 20, 2021, while the USD LIBOR conversation is currently being planned.

While consultation is open until July 5, 2022, the proposed change was unanimously welcomed during a pre-consultation with industry representatives. In particular, industry representatives supported the decision not to extend the clearing obligation to CHF interest rate derivatives linked to SARON. Due to the relatively small size of the market, such an extension is currently not necessary, especially since a large proportion of SARON contracts are already voluntarily centrally cleared, which further reduces systemic risk.

In its response to the CFTC’s similar consultation, the International Swaps and Derivatives Association (ISDA) asked to consider an exemption from the clearing mandate applicable to ARR swaps in the case of transactions resulting from exercises such as multilateral cycles. risk rebalancing schemes, which reduce uncleared counterparty credit risk and/or transfer existing risk from the uncleared space to central counterparties. With the extension of the clearing obligation to ARR swaps, such risk management practices, currently applied by many large dealer banks, could be undermined, as OIS as a negotiable instrument for interest rate risk. compensated and uncompensated interest would no longer be available.

Next steps

Changes to the clearing obligation will have a cost, for example for system changes, changes to the control framework, documentation and training. To reduce these costs, it is important to start adapting early so that you are not forced to adopt tactical solutions to meet short deadlines. Based on previous experience, market participants need a minimum of 6 months to implement new clearing obligations.

For market participants who already have clearing processes in place, they can already think about how to adapt these processes to integrate new interest rate derivatives into the clearing eligibility criteria.

For market participants who do not yet have clearing processes in place but (plan to) trade the new interest rate derivatives subject to the clearing obligation, they will need to consider whether the respective clearing processes should be established or whether the types of derivatives traded need to be revisited. For those smaller, less sophisticated counterparties that do not currently have to clear, the clearing obligation could represent a significant cost that could deter them from hedging using swaps if not handled appropriately. early in advance.