Cross currency basics 3 - Pricing and Revaluation Rate Sources

On 5 and 19 January 2022 I posted blogs looking at the basic features and some pricing examples of cross-currency markets. The focus was on the ways in which end users of cross currency swaps price and transact in the markets. In many cases, the concepts can be complex to understand, and the pricing can be difficult to unravel.

Many users are currently experiencing significant revaluation issues as the markets change from using USD LIBOR to USD SOFR as the basis for pricing. Screens and data sources are often unclear on which reference rate is being used. Pages and tickers that may have been sourced for many years have changed their reference rates which can cause disruption in the revaluation process. This can lead to differences in collateral requirements and accounting entries.

This blog looks at several currencies where the connection between the Risk-Free Rate (RFR) and LIBOR versions of the cross-currency market quotes may be less than clear. As the reference rates and market conventions change then what you see on a screen can also change.

Current market conventions

Cross-currency market quotes were, until late 2021, quoted against USD LIBOR and the currency IBOR. The ‘SOFR First’ effort of late 2021 encouraged cross-currency markets in the LIBORs to move to RFRs in late September 2021 and other, non-LIBOR currencies in December 2021. Now (February 2022), cross-currency swaps are commonly referenced to USD SOFR and the currency RFR.

Examples are:

                                           Up to late 2021                Current

EUR/USD            LIBOR/Euribor                 SOFR/€STR

GBP/USD            LIBOR/LIBOR                    SOFR/SONIA

JPY/USD              LIBOR/LIBOR                    SOFR/TONA

AUD/USD           LIBOR/BBSW                    SOFR/BBSW

CAD/USD            LIBOR/CDOR                    SOFR/CDOR and SOFR/CORRA

The two standouts are AUD and CAD.

In the AUD case, the markets currently adopt a mis-match approach with the AUD leg continuing with BBSW rather than AONIA (RFR).

CAD is quoting both CDOR and CORRA (RFR) but has announced the discontinuation of CDOR so I expect CORRA to prevail in the near future.

Other markets have local IBORs still being used mainly because of a lack of viable RFRs.

Pricing differences

How do the new quotes appear relative to the old versions? The following table might help with examples for the 5-year cross currency (XCCY) swaps. It shows the actual quotes for cross-currency trades and the LIBOR rates derived from the quotes and the relevant IBOR/RFR basis swaps.

Firstly a few key notes:

• The IBOR/RFR spread for GBP and JPY is fixed since the LIBOR pre-cessation announcement on 5 March 2021

• Other IBOR/RFR spreads are market rates

The quoted rate does differ (column 4) from the derived rate (column 6) particularly in the JPY/USD. I suspect the market quotes are using a simple calculation (i.e., subtracting the currency IBOR/RFR from the SOFR/LIBOR spread) and perhaps do not fully adjust for convexity. This will make a larger difference in JPY due to the interest rate differential between JPY and USD.  

Quote implications for users

When you price a new trade or revalue an existing trade, it is essential you understand the quote basis of your price. The quote difference (column 5) shows how much the quotes can differ between the LIBOR (column 4) and RFR (column 2) versions.

In several cases, the actual reference rates are not clear in the screen quotes which can make the process of using the correct basis somewhat challenging for some users. Certainly, we have seen this when advising our clients.

System implications for users

Booking and valuation systems are also challenging for many users. If the quotes are using different reference rates to your trades, then they must be correctly transformed into the ones required. For example, if your trade is USD LIBOR/ Euribor and the quoted price is SOFR/€STR then your system will need some additional basis swaps, SOFR/LIBOR and €STR/Euribor, and the algorithm to incorporate them into the valuations to make all this work.

In many cases, systems are simply unable to use multiple basis swaps because they have not been updated with the required patches. When this situation occurs, the calculations must be performed ex-system and the required cross-currency basis swaps (e.g., LIBOR/Euribor) then used for revaluation.

This is a complex, manual process but cannot be avoided if the system cannot manage the new quotes.

Summary

Moving from the LIBOR/IBOR cross-currency market quotes to the new quotes has been a challenging process for many users.

Many quotes are now based on SOFR but many trades still reference USD LIBOR, at least until 30 June 2023. Some quotes use the currency RFR while others use the existing IBOR (AUD). Some are in the process of moving from the currency IBOR to the RFR (CAD).

It is essential to get the pricing and revaluations correct to ensure the accounting entries are accurate and collateral calculations, where required, will align with those of the counterparty.

Systems for pricing and recording cross-currency swaps often need to be updated. Where this is not possible, then some calculations will have to be done outside the system and the required rates then entered into your system in a second step.

Martialis is actively supporting our clients in this effort. We are seeing quite a few challenges, but careful analysis and planning can make the transition to new cross-currency markets and quotes a little less painful.