Recently, we have embarked on a process to align more effectively what we do with the changing needs of our clients in unprecedented times. A central pillar of this exercise was an in-depth dialogue with our clients and business partners around the world. These conversations confirmed that Zanders is trusted to translate our deep financial consultancy knowledge into solutions that answer the biggest and most complex problems faced by the world's most dynamic organizations. Our goal is to help these organizations withstand the current macroeconomic challenges and help them emerge stronger. Our purpose is grounded on the above.

"Zanders is trusted to translate our deep financial consultancy knowledge into solutions, answering the biggest and most complex problems faced by the world's most dynamic organizations."

Laurens Tijdhof

Our purpose is a reflection of what we do now, but it's also about what we need to do in the future.

It reflects our ongoing ambition - it's a statement of intent - that we should and will do more to affect positive change for both the shareholders of today and the stakeholders of tomorrow. We don't see that kind of ambition as ambitious; we see it as necessary.

The Zanders’ purpose is about the future. But it's also about where we find ourselves right now - a pandemic, high inflation and rising interest rates. And of course, climate change. At this year's Davos meeting, the latest Disruption Index was released showing how macroeconomic volatility has increased 200% since 2017, compared to just 4% between 2011 and 2016.

So, you have geopolitical volatility and financial uncertainty fused with a shifting landscape of regulation, digitalization, and sustainability. All of this is happening at once, and all of it is happening at speed.

The current macro environment has resulted in cost pressures and the need to discover new sources of value and growth. This requires an agile and adaptive approach. At Zanders, we combine a wealth of expertise with cutting-edge models and technologies to help our clients uncover hidden risks and capitalize on unseen opportunities.

However, it can't be solely about driving performance during stable times. This has limited value these days. It must be about delivering performance despite macroeconomic headwinds.

For over 30 years, through the bears, the bulls, and black swans, organizations have trusted Zanders to deliver financial performance when it matters most. We've earned the trust of CFOs, CROs, corporate treasurers and risk managers by delivering results that matter, whether it's capital structures, profitability, reputation or the environment. Our promise of "performance when it counts" isn't just a catchphrase, but a way to help clients drive their organizations, economies, and the world forward.

"For over 30 years, through the bears, the bulls, and black swans, financial guardians have trusted Zanders to deliver financial performance when it matters most."

Laurens Tijdhof

What "performance when it counts" means.

Navigating the current changing financial environment is easier when you've been through past storms. At Zanders, our global team has experts who have seen multiple economic cycles. For instance, the current inflationary environment echoes the Great Inflation of the 1970s. The last 12 months may also go down in history as another "perfect storm," much like the global financial crisis of 2008. Our organization's ability to help business and government leaders prepare for what's next comes from a deep understanding of past economic events. This is a key aspect of delivering performance when it counts.

The other side of that coin is understanding what's coming over the horizon. Performance when it counts means saying to clients, "Have you considered these topics?" or "Are you prepared to limit the downside or optimize the upside when it comes to the changing payments landscape, AI, Blockchain, or ESG?" Waiting for things to happen is not advisable since they happen to you, rather than to your advantage. Performance when it counts drives us to provide answers when clients need them, even if they didn't know they needed them. This is what our relationships are about. Our expertise may lie in treasury and risk, but our role is that of a financial performance partner to our clients.

How technology factors into delivering performance when it counts.

Technology plays a critical role in both Treasury and Risk. Real-time Treasury used to be an objective, but it's now an imperative. Global businesses operate around the clock, and even those in a single market have customers who demand a 24/7/365 experience. We help transform our clients to create digitized, data-driven treasury functions that power strategy and value in this real-time global economy.

On the risk management front, technology has a two-fold power to drive performance. We use risk models to mitigate risk effectively, but we also innovate with new applications and technologies. This allows us to repurpose risk models to identify new opportunities within a bank's book of business.

We can also leverage intelligent automation to perform processes at a fraction of the cost, speed, and with zero errors. In today's digital world, this combination of next generation thinking, and technology is a key driver of our ability to deliver performance in new and exciting ways.

"It’s a digital world. This combination of next generation of thinking and next generation of technologies is absolutely a key driver of our ability to deliver performance when it counts in new and exciting ways."

Laurens Tijdhof

How our purpose shapes Zanders as a business.

In closing, our purpose is what drives each of us day in and day out, and it's critical because there has never been more at stake. The volume of data, velocity of change, and market volatility are disrupting business models. Our role is to help clients translate unprecedented change into sustainable value, and our purpose acts as our North Star in this journey.

Moreover, our purpose will shape the future of our business by attracting the best talent from around the world and motivating them to bring their best to work for our clients every day.

"Our role is to help our clients translate unprecedented change into sustainable value, and our purpose acts as our North Star in this journey."

Laurens Tijdhof

Alternatives for a calculating compounded SARON

After explaining in the previous article the use of compounded SARON as a term alternative to CHF LIBOR, the Swiss National Working Group (NWG) published several options as to how a compounded SARON could be used as a benchmark in banking products, such as loans or mortgages, and financial instruments (e.g. capital market instruments). Underlying these options is the question of how to best mitigate uncertainty about future cash flows, a factor that is inherent in the compounding approach. In general, it is possible to separate the type of certainty regarding future interest payments in three categories . The market participant has:

• an aversion to variable future interest payments (i.e. payments ex-ante unknown). Buying fixed-rate products is best, where future cash flows are known for all periods from inception. No benchmark is required due to cash flow certainty over the lifetime of the product.
• a preference for floating-rate products, where the next cash flow must be known at the beginning of each period. The option ‘in advance’ is applicable, where cash flow certainty exists for a single period.
• a preference for floating-rate products with interest rate payments only close to the end of the period are tolerated. The option ‘in arrears’ is suitable, where cash flow certainty only close to the end of each period exists.

Based on the Financial Stability Board (FSB) user’s guide, the Swiss NWG recommends considering six different options to calculate a compounded risk-free rate (RFR). Each financial institution should assess these options and is recommended to define an action plan with respect to its product strategy. The compounding options can be segregated into options where the future interest rate payments can be categorized as in arrears, in advance or hybrid. The difference in interest rate payments between ‘in arrears’ and ‘in advance’ conventions will mainly depend on the steepness of the yield curve. The naming of the compounding options can be slightly different among countries, but the technique behind those is generally the same. For more information regarding the available options, see Figure 1.

Moreover, for each compounding technique, an example calculation of the 1-month compounded SARON is provided. In this example, the start date is set to 1 February 2019 (shown as today in Figure 1) and the payment date is 1 March 2019. Appendix I provides details on the example calculations.

Figure 1: Overview of alternative techniques for calculating compounded SARON. Source: Financial Stability Board (2019).

0) Plain (in arrears): The observation period is identical to the interest period. The notional is paid at the start of the period and repaid on the last day of the contract period together with the last interest payment. Moreover, a Plain (in arrears) structure reflects the movement in interest rates over the full interest period and the payment is made on the day that it would naturally be due. On the other hand, given publication timing for most RFRs (T+1), the requiring payment is on the same day (T+1) that the final payment amount is known (T+1). An exception is SARON, as SARON is published one business day (T+0) before the overnight loan is repaid (T+1).

Example: the 1-month compounded SARON based on the Plain technique is like the example explained in the previous article, but has a different start date (1 February 2019). The resulting 1-month compounded SARON is equal to -0.7340% and it is known one day before the payment date (i.e. known on 28 February 2019).

1) Payment Delay (in arrears): Interest rate payments are delayed by X days after the end of an interest period. The idea is to provide more time for operational cash flow management. If X is set to 2 days, the cash flow of the loan matches the cash flow of most OIS swaps. This allows perfect hedging of the loan. On the other hand, the payment in the last period is due after the payback of the notional, which leads to a mismatch of cash flows and a potential increase in credit risk.

Example: the 1-month compounded SARON is equal to -0.7340% and like the one calculated using the Plain (in arrears) technique. The only difference is that the payment date shifts by X days, from 1 March 2019 to e.g. 4 March 2019. In this case X is equal to 3 days.

2) Lockout Period (in arrears): The RFR is no longer updated, i.e. frozen, for X days prior to the end of an interest rate period (lockout period). During this period, the RFR on the day prior to the start of the lockout is applied for the remaining days of the interest period. This technique is used for SOFR-based Floating Rate Notes (FRNs), where a lockout period of 2-5 days is mostly used in SOFR FRNs. Nevertheless, the calculation of the interest rate might be considered less transparent for clients and more complex for product providers to be implemented. It also results in interest rate risk that is difficult to hedge due to potential changes in the RFR during the lockout period. The longer the lockout period, the more difficult interest rate risk can be hedged during the lockout period.

Example: the 1-month compounded SARON with a lockout period equal to 3 days (i.e. X equals 3 days) is equal to -0.7337% and known 3 days in advance of the payment date.

3) Lookback (in arrears): The observation period for the interest rate calculation starts and ends X days prior to the interest period. Therefore, the interest payments can be calculated prior to the end of the interest period. This technique is predominately used for SONIA-based FRNs with a delay period of X equal to 5 days. An increase in interest rate risk due to changes in yield curve is observed over the lifetime of the product. This is expected to make it more difficult to hedge interest rate risk.

Example: assuming X is equal to 3 days, the 1-month compounded SARON would start in advance, on January 29, 2019 (i.e. today minus 3 days). This technique results in a compounded 1-month SARON equal to -0.7335%, known on 25 February 2019 and payable on 1 March 2019.

4) Last Reset (in advance): Interest payments are based on compounded RFR of the previous period. It is possible to ensure that the present value is equivalent to the Plain (in arrears) case, thanks to a constant mark-up added to the compounded RFR. The mark-up compensates the effects of the period shift over the full life of the product and can be priced by the OIS curve. In case of a decreasing yield curve, the mark-up would be negative. With this technique, the product is more complex, but the interest payments are known at the start of the interest period, as a LIBOR-based product. For this reason, the mark-up can be perceived as the price that a borrower is willing to pay due to the preference to know the next payment in advance.

Example: the interest rate payment on 1 March 2019 is already known at the start date and equal to -0.7328% (without mark-up).

5) Last Recent (in advance): A single RFR or a compounded RFR for a short number of days (e.g. 5 days) is applied for the entire interest period. Given the short observation period, the interest payment is already known in advance at the start of each interest period and due on the last day of that period. As a consequence, the volatility of a single RFR is higher than a compounded RFR. Therefore, interest rate risk cannot be properly hedged with currently existing derivatives instruments.

Example: a 5-day average is used to calculate the compounded SARON in advance. On the start date, the compounded SARON is equal to -0.7339% (known in advance) that will be paid on 1 March 2020.

6) Interest Rollover (hybrid): This technique combines a first payment (installment payment) known at the beginning of the interest rate period with an adjustment payment known at the end of the period. Like Last Recent (in advance), a single RFR or a compounded RFR for a short number of days is fixed for the whole interest period (installment payment known at the beginning). At the end of the period, an adjustment payment is calculated from the differential between the installment payment and the compounded RFR realized during the interest period. This adjustment payment is paid (by either party) at the end of the interest period (or a few days later) or rolled over into the payment for the next interest period. In short, part of the interest payment is known already at the start of the period. Early termination of contracts becomes more complex and a compensation mechanism is needed.

Example: similar to Last Recent (in advance), a 5-day compounded SARON can be considered as installment payment before the starting date. On the starting date, the 5-day compounded SARON rate is equal to -0.7339% and is known to be paid on 1 March 2019 (payment date). On the payment date, an adjustment payment is calculated as the delta between the realized 1-month compounded SARON, equal to -0.7340% based on Plain (in arrears), and -0.7339%.

There is a trade-off between knowing the cash flows in advance and the desire for a payment structure that is fully hedgeable against realized interest rate risk. Instruments in the derivatives market currently use ‘in arrears’ payment structures. As a result, the more the option used for a cash product deviates from ‘in arrears’, the less efficient the hedge for such a cash product will be. In order to use one or more of these options for cash products, operational cash management (infrastructure) systems need to be updated. For more details about the calculation of the compounded SARON using the alternative techniques, please refer to Table 1 and Table 2 in the Appendix I. The compounding formula used in the calculation is explained in the previous article.

Overall, market participants are recommended to consider and assess all the options above. Moreover, the financial institutions should individually define action plans with respect to their own product strategies.

Conclusions

The transition from IBOR to alternative reference rates affects all financial institutions from a wide operational perspective, including how products are created. Existing LIBOR-based cash products need to be replaced with SARON-based products as the mortgages contract. In the next installment, IBOR Reform in Switzerland – Part III, the latest information from the Swiss National Working Group (NWG) and market developments on the compounded SARON will be explained in more detail.

Appendix I – II

Contact

For more information about the challenges and latest developments on SARON, please contact Martijn Wycisk or Davide Mastromarco of Zanders’ Swiss office: +41 44 577 70 10.

The other articles on this subject: 

Transition from CHF LIBOR to SARON, IBOR Reform in Switzerland, Part I
Compounded SARON and Swiss Market Development, IBOR Reform in Switzerland, Part III
Fallback provisions as safety net, IBOR Reform in Switzerland, Part IV

References

1. Mastromarco, D. Transition from CHF LIBOR to SARON, IBOR Reform in Switzerland – Part I. February 2020.
2. National Working Group on Swiss Franc Reference Rates. Discussion paper on SARON Floating Rate Notes. July 2019.
3. National Working Group on Swiss Franc Reference Rates. Executive summary of the 12 November 2019 meeting of the National Working Group on Swiss Franc Reference Rates. Press release November 2019.
4. National Working Group on Swiss Franc Reference Rates. Starter pack: LIBOR transition in Switzerland. December 2019.
5. Financial Stability Board (FSB). Overnight Risk-Free Rates: A User’s Guide. June 2019.
6. ISDA. Supplement number 60 to the 2006 ISDA Definitions. October 2019.
7. ISDA. Interbank Offered Rate (IBOR) Fallbacks for 2006 ISDA Definitions. December 2019.
8. National Working Group on Swiss Franc Reference Rates. Executive summary of the 7 May 2020 meeting of the National Working Group on Swiss Franc Reference Rates. Press release May 2020