Derivatives Market Update for Financial Institutions
Matthew Tevis - Leadership
We have baseball on our minds in Philadelphia these days. As the great Yogi Berra once said, “It’s like déjà vu all over again.” Not so much about the World Series (since it has been 13 long years since the Phillies have played in the big game), but rather about the Federal Reserve. As we were finalizing our newsletter last quarter, the Fed increased its benchmark rate by 75 basis points. Yesterday we saw the same action by the FOMC. It is hard to believe we started the year with a Fed Funds range of 0–0.25%. After six hikes in only nine months, we now sit at 3.75%–4.00%. And the market currently expects another 100-basis-point rise by the end of the first quarter in 2023.
This large rate movement as well as increased market uncertainty have caused many financial institutions to implement hedging strategies to help protect earnings, minimize the impact on AOCI, and reduce funding costs. Our Balance Sheet Risk Management desk, who works closely with our bank and credit union clients to structure customized strategies, provides some excellent market color. They talk about the mix of activity including hedging objectives, structures, and underlying hedged items. Although swaps remain the most popular tool, the heightened market volatility has increased the relative attractiveness of zero-cost collars and other option strategies.
Our Trading desk shares some perspective on Term SOFR and the impact on dealer pricing as these banks manage a growing exposure to the basis risk between Term SOFR and SOFR compound. Keeping with the theme of LIBOR replacement, our Client Relationship Management team talks about how our financial institution clients are preparing for the transition date, now less than eight months away (and even sooner for cleared trades). Our Accounting team highlights the FASB’s recent decision to extend the sunset date of the temporary reference rate reform relief guidance in Topic 848 to year-end 2024.
Our Product Management team describes the CFTC’s revisions to its rules governing swap data reporting. Two key areas for your review and action include confirming Chatham has a Legal Entity Identifier and the Federal Entity status for all of your borrowers prior to December 5. On a more personal note, please meet our colleague Eric Detzel who has been at Chatham for over 10 years and leads our Software Engineering team. He played soccer at Mount St. Mary’s and is an avid Arsenal FC fan. Lastly, we hope to see you at one of the many conferences we will be speaking at over the next few months. Go Phillies!
Todd Cuppia- Balance Sheet Risk Management
Interest rate volatility has continued with a relentless march upward as uncertainty around large-scale macroeconomic and geopolitical risks remains in the market narrative. The themes we have shared with you all year are still largely in place, and, in some cases, activity in certain areas is accelerating with the move higher in interest rates. The year began with roughly balanced hedging across our client base but flows quickly became overwhelmed by financial institutions looking to lock in historically attractive yields on floating rate assets. As the fourth quarter has progressed, nearly 78% of the activity on the desk has been to hedge a portion of the balance sheet against the risk of falling rates.
Hedging for potential falling short-term rates
- Floating rate asset pools have traditionally been the go-to source for derivative hedging strategies, especially when lending is relatively standardized within a particular asset class. In this stage of the cycle, we have seen activity across a wide range of lending products and portfolios. We often see activity concentrated in hedging floating-rate commercial real estate loans. Given the large amount of hedging needs in the current market, however, we have seen an increase in the hedging of credit card receivables, SBA Loans, CLOs, home equity lines of credit, reserve balances, and other cash equivalents. Each asset class has different nuances that factor into the approach of our review process and the hedging strategies we recommend.
- Given the steepness in the front end of the forward curve and the increasing inversion further out, we often help financial institutions review the most cost-effective approach to structuring hedges that allow for increasing benefit if rates continue to rise but protect a core portion of the portfolio from a potential economic downturn. Market volatility has increased the relative attractiveness of collars to maximize potential benefits while minimizing cost. As a recent example, we structured a 3-year zero-cost collar on CME Term SOFR commercial real estate loans with a 2.50% floor and 6.00% cap. The increase in options-based strategies has reintroduced an essential concept into the hedging playbook, understanding the supply/demand dynamic of these less liquid market areas. Frequently collars, or other cap and floor strategies, are priced such that the option strikes are placed 100 basis points or more out-of-the-money relative to the equivalently structured vanilla swap. For those active in these markets, execution strategy is a critical component of the overall approach.
- In addition to hedging floating-rate assets, we have also seen an increase in financial institutions swapping longer-term fixed-rate liabilities for floating. While less common and often smaller in size given a typical community/regional bank balance sheet structure, we have assisted clients in hedging sub debt, longer-term CDs (both brokered and retail), longer-term FHLB advances, as well as bond securitization and loan sale programs.
Hedging for rising rates, AOCI hedging
- Given the significant pressure on financial institution bond portfolios with the surge in yields, we continue to see strong interest in strategies that help manage Accumulated Other Comprehensive Income (AOCI) risk. The strategy usually revolves around two different approaches.
- Using pay-fixed swap strategies to hedge AFS securities. Commonly, we see banks aggregate their holdings of long-duration municipal bonds, MBS, CMOs, or CMBS securities in a pool and apply a hedge to mitigate the portfolio’s price sensitivity. The strategy is flexible to implement and can be customized to the institutions’ particular risk/reward preferences.
- After a period of relative absence, banks have returned to borrowing from the FHLB in a big way to bolster their liquidity, given the increased competition for deposits and a decline in the market value of on-balance sheet liquidity sources. Often the most cost-effective way to borrow from the FHLB is to pair a short-term advance with a swap or a cap. This has been a popular strategy for many years since the market value of the derivative will gain in value in a rising-rate scenario and is marked to market through AOCI, giving you a natural offset to the risk in the AFS portfolio. This type of transaction has had a resurgence in popularity in the last few months. Similarly, we have seen an increase in deposit hedging strategies.
Trading desk trends
Brett McHugh, - Trading Desk
With inflation still running hot and the expectation of more rate hikes to come this year, we have continued to see hedging activity come in waves. Transaction volume increased from the previous quarter despite the rise in rates.
The rising-rate environment has led to borrowers continuing to terminate swaps to take advantage of their assets positions. We have seen some clients look to hedge down rate risk by purchasing floors on swaps at a relatively low cost compared to just a year ago. We have also seen an uptick in inquiries regarding cancelable swap structures.
As expected, Term SOFR origination pricing has widened due to dealers’ exposure to the Term SOFR - SOFR compound basis risk. For existing LIBOR trades, dealers have continued to widen out slightly, however, we have been able to save our clients substantial execution costs by putting cleared trades in competition rather than only going back to the incumbent dealer.
Update on LIBOR
Scott Rosenblum - Client Relationship Management
With the cessation of LIBOR less than eight months away (and even sooner for cleared trades), preparation for this transition has hit full speed. Many institutions have already chosen a clear path forward, while others are still contemplating the various options available. Regardless of the routes institutions choose to take, the discussion is largely centered around operational ability versus cost.
For non-cleared transactions, many institutions have already prepared by using the mechanisms for an automatic switch to Fallback Rate (SOFR or Fallback SOFR). These mechanisms (e.g., adhering to the ISDA IBOR Fallbacks Protocol) pave the way for their swaps to automatically switch to Fallback SOFR after June 30, 2023. Others have chosen to convert LIBOR trades on a bilateral basis to something other than Fallback SOFR, most commonly CME Term SOFR. Others still have employed a wait-and-see approach, contemplating the benefits and drawbacks of various alternative indexes.
The economic cost of allowing trades to move to Fallback SOFR automatically is quite low. However, operational aspects of Fallback SOFR need to be considered. Systems and processes must be capable of handling an in-arrears rate where payment amounts may not be known until two-days prior to the payment date. Conversely, those who early convert trades to a different index (e.g., CME Term SOFR — a forward-looking rate) may alleviate some of the operational hurdles but will face economic costs associated with converting. Banks may incur hard transaction costs when amending dealer and borrower trades, as well as soft opportunity costs associated with engaging with borrowers in conversations about adjusting the loan spread to compensate for the difference between LIBOR and CME Term SOFR.
For financial institutions that have cleared LIBOR trades, there is an added wrinkle of how the central counterparties (CME and LCH) are transitioning LIBOR swaps. Centrally cleared LIBOR swaps are scheduled to transition to spread-adjusted SOFR OIS Compound swaps which are similar to, but slightly different from, Fallback SOFR swaps. These differences can be benign in low volatility rate environments but can become much larger when volatility picks up as we have seen in 2022.
Chatham believes that the correct approach to the transition will vary based on the institution’s size, book of trades, operational capabilities, willingness for mismatches, and cost recognition. Please reach out to your Client Relationship Manager to talk about all aspects of the transition and discuss solutions that work best for your institution.
Eri Panoti - Accounting Advisory
On October 5, the Financial Accounting Standards Board (FASB) voted to extend the sunset date of the temporary reference rate reform relief guidance in Topic 848 to December 31, 2024. For derivative transactions designated in a hedge accounting relationship, this guidance allows the continuation of hedge accounting while contracts are being amended to non-LIBOR rates. Companies also can bypass some of the stringent qualification and subsequent measurement criteria required under ASC 815. While we expect most financial institutions to transition away from LIBOR by June 30, 2023, this extension provides more flexibility in reducing the risk of financial statement impact from reference rate reform related activities. The final guidance is expected to be released by year end.
In the same board meeting, the FASB voted to not allow for the addition of any new indexes as benchmark interest rates, including BSBY, AMERIBOR, and CME Term SOFR. To avoid influencing the market on any emerging replacement rates for LIBOR, the FASB decided to put a moratorium on this topic until reference rate reform is complete. Cash flow hedges of floating-rate exposure are not affected by this ruling. Companies are still able to hedge the contractually specified rate as the hedged risk and not rely on the prescribed list of benchmark rates. However, this decision does affect cash flow hedges of a future issuance of debt as well as fair value hedges, where entities rely on the available list of benchmark rates to achieve hedge accounting.
Elizabeth Thorwart - Product Management
Dodd-Frank reporting rule change
December 5, 2022 is the compliance date for the CFTC’s revisions to its rules governing swap data reporting. Chatham’s regulatory advisory and technology teams continue to prioritize your institution’s compliance with the new reporting rules. There are two key areas that internal policies reflect the new requirements.
- Legal Entity Identifier (LEI)
- DTCC, your Swap Data Repository, will now validate submissions to ensure that both parties for a swap have obtained an LEI. If you have existing borrowers in our system where we do not have an LEI on file, your Client Relationship Manager has been in contact to obtain this information. Please ensure that Chatham has an LEI on file for all your borrowers prior to December 5.
- The only exception to the LEI requirement is Natural Persons. We have confirmed with you all your existing borrowers that qualify as Natural Persons and added a new field over the summer to capture this detail going forward.
- We also urge our clients to be prepared to gather this information pre-trade and ensure that policies appropriately capture the LEI registration requirements for borrowers. At execution, Chatham will let you know if a borrower does not have an LEI, but we will not prevent you from hedging. However, an LEI will be required before we can report the transaction to the DTCC. Learn more about how Chatham will help you meet the LEI requirement.
- Federal Entity
- The CFTC added a new field, Federal Entity Indicator, to its technical specifications. Over the summer, we added a new field to capture this detail going forward. It will be required for DTCC to accept our submissions.
- Your Client Relationship Manager will be in touch soon to obtain this information for your existing borrowers. We will need to have this information for all parties to do a reportable trade prior to December 5.
Upgrading active trades
On the Compliance Date, the CFTC requires that all active transactions be upgraded to include the new data fields and values to comply with the revised rules.
On December 5, Chatham will complete a bulk reporting action to ensure all, about 14,000 reportable trades in our system comply with the new rules. To complete this exercise for you, we will need your help to ensure we have LEIs and the Federal Entity status for all your institution’s borrowers. Without this information, we will be unable to upgrade your positions. The market has agreed to upgrade all positions, as required by the CFTC, by January 15, 2023; however, Chatham will work with the intention of completing this exercise in the week immediately following the Compliance Date
Chatham’s current and planned work on behalf of our clients
Valuation reporting requirement
Non-Swap Dealers (non-SD/MSPs) no longer have a quarterly valuation reporting requirement. We submitted quarterly valuations for your transactions on September 30. This will be the last quarterly valuation submission for non-SD/MSPs.
Confirmation data reporting
All market participants no longer have the requirement to include the confirmation method and confirmation date in their regulatory submissions. While it remains a market best practice to have a fully executed confirmation within T+2, this information will no longer be actively reported to the CFTC. You should ensure your institution maintains your policies and procedures surrounding timely confirmation execution; in a record-keeping audit, the CFTC will inspect confirmation data.
Chatham has document storage available to you on the transaction level that meets the CFTC’s record-keeping requirements. If your firm does not already use Chatham’s systems for documentation storage, reach out to your Client Relationship Manager to understand how we can store fully executed trade confirmations.
Swap data validation
Quarterly, your institution will have a reconciliation requirement to validate that all fields on the Trade State report accurately reflect transaction data. As your system of record, Chatham is actively designing a solution to meet your needs. Our solution will include additional operational controls to ensure your data is accurately represented at the DTCC and to the CFTC. Your Client Relationship Manager will be in touch with you to discuss this new service. The first quarterly reconciliation will take place in March 2023.
Eric Detzel – Technology
How long have you been at Chatham and what is your current role?
I have been with Chatham for 10 years, leading the Financial Institutions Software Engineering team for the past seven. During my time here, the team has grown from four members to 20 members located in our Denver and Kennett Square office locations. Throughout my time at Chatham, the software engineering team has sought to ensure quality, innovation, and stability in every product they build. By adhering to the latest industry standards in software architecture, delivery, security, performance, and testing, the team has been able to deliver best-in-class, enterprise-level software to meet the growing needs of Chatham's financial institution clients. Additionally, the team has made a strong investment in learning and development to help individuals achieve professional growth while injecting higher velocity and expertise into the software development process. This, in tandem with a commitment to building healthy working relationships amongst team members, is what I believe are two of the fundamental pieces of delivering high-quality software in the ChathamDirect platform.
What do you enjoy doing outside of work?
I grew up in York, Pennsylvania, and attended Mount St. Mary's University where I majored in math and computer science. I played soccer in college and was named to the CapitalOne Academic All-America first team. I also play several instruments at a somewhat pedestrian level and am an avid Arsenal FC fan.
Come see us at these upcoming events
RKL's Credit Union Conference
Bob Newman will speak at this event in Phoenixville, PA on November 2.
GBA’s Financial Risk Management conference
Bob Newman will speak at this event in Atlanta, GA from November 3–4
CBB’s 35th Anniversary Celebration
Ben Lewis will speak at this event in Pinehurst, NC from November 13–16
Chris Funck will attend this event in Austin, TX from November 15–17
PICBA Insurance and Financial Institutions conference
Bob Newman will speak at this event in King of Prussia, PA on December 2
Philly Fed IRR Panel discussion
Bob Newman will speak at this event in Philadelphia, PA on December 15
Acquire or Be Acquired conference
David Sweeney and Todd Cuppia will speak and exhibit at this event from January 29–31
Connect with a Chatham expert who can answer your questions.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.22-0285