What is the issue?
As discussed in our earlier alert, in July 2020 clearing houses that clear EUR denominated products (LCH, Eurex and CME) changed the discount rates they use for valuing cleared OTC derivatives for EUR denominated trades. This was achieved by replacing references to EONIA with €STR flat and applying cash compensation (by different mechanisms) to neutralise the resulting valuation difference at the present value of the 8.5 basis points spread between €STR and EONIA.This created a mismatch between the valuations of cleared and uncleared products, as uncleared OTC derivatives are typically valued using a discount rate based upon the interest rate payable on cash collateral under the CSA between the parties.
By far the most prevalent of those rates is EONIA for EUR.
Most banks acknowledged the need to reduce this gap by aligning the interest rates in their CSAs to the CCP discount rates. Some banks have been quietly getting on with this, others are less advanced. Agreement as to the appropriate level of compensation, if any, has complicated this process. We understand that many participants have made this switch without even agreeing to pay compensation at all.
Whether or not parties want to achieve economic valuation alignment between cleared and uncleared OTC derivatives they will have to replace references to EONIA with €STR by latest 3 January 2022 as EONIA will be discontinued from that date. This change, at least with respect to collateral agreements, will not have a legislative solution and it is not covered by the 2020 ISDA IBOR Fallbacks Protocol.
What does the Protocol do?
On 19 August 2021, ISDA published the EONIA Collateral Agreement Fallbacks Protocol (the "Protocol") which will enable market participants to amend the terms of their ISDA collateral agreements to incorporate a fallback to €STR plus 8.5 basis points upon the cessation of EONIA in order to ensure the continued viability of EUR CSAs which have not been bilaterally amended. It achieves this by replacing any reference to EONIA in an ISDA collateral agreement to "EONIA (Collateral Rate)" as defined in the ISDA 2020 Collateral Agreement Interest Rate Definitions (Version 2.0) published in August 2020. Those Definitions contain fallbacks in the case of the cessation of certain referencing rates including EONIA. In the case of EONIA the fallback is to €STR plus 8.5 basis points.By incorporating that definition, the Protocol removes the commercial discussion between adhering parties regarding compensation as there is no economic change in interest rate and therefore discounting for the uncleared OTC derivatives collateralised under the relevant CSA. However, the Protocol does not alleviate the ongoing basis difference between cleared and uncleared OTC discount rates. So, whilst it fixes one problem, it leaves the primary economic issue unchanged; and the mismatch remains.
A couple of points on the Protocol:
- There is no closing date, although practically it needs to have been adhered to by the end of 2021
- It is effective as between two adhering parties when the later of those adheres
- It only applies to collateral agreements which have been signed at the effective date, on the basis that parties should now be entering into new collateral agreements based on €STR
- It retains any spread to EONIA, in addition to the 8.5 basis point spread to €STR
- It does not introduce negative interest rates where these have not been agreed and neither does it impact the ISDA 2014 Collateral Agreement Negative Interest Protocol if that is applicable between the parties
- Unlike the ISDA 2020 IBOR Fallbacks Protocol, it only applies to ISDA collateral agreements and will not apply to FBFs, GMRAs or GMSLAs, etc. These will need to be manually amended unless there is a protocol solution to make the change. The DRV is covered by neither of course and no protocol solution should be expected
- It does not apply where the parties have separately agreed a fallback rate or mechanism in their collateral agreement
Whilst the continued mismatch with cleared trades may not be material for some portfolios, it may have a significant impact on larger and dynamic portfolios or where parties have agreed to roll forward long standing breaks on this like negative interest. Whilst we expect market participants to widely adhere to the Protocol and need not consider the economic impact of doing so, market participants should still pursue bilateral negotiation of a switch to €STR flat to solve the primary issue that the valuations of cleared and uncleared products are currently mismatched. So it is perhaps more of a sticking plaster than a medium to long-term solution.
If you have any questions about the Protocol or the economic implications of changing EUR CSAs to €STR, please do not hesitate to contact us.
Monique Marino
Guy Usher
Steven Burrows
Edward Miller