Compounded SARON and Swiss Market Development
IBOR Reform in Switzerland, Part III
The Swiss Average Rate Overnight (SARON) is expected to replace CHF LIBOR by the end of 2021. The transition to this new reference rate includes debates concerning the alternative methodologies for compounding SARON. This article aims to provide the latest updates on the Swiss National Working Group’s (NWG) view and latest market development on compounded SARON.
In our previous article, the challenges associated with the compounding alternatives for the new reference rate (SARON) as an alternative to CHF LIBOR were explained and details about the calculation of the compounded SARON using the alternative techniques were exposed. This article aims to updates the reader to the latest information from the Swiss National Working Group (NWG) and the latest market development on the compounded SARON.
View of Swiss National Working Group (NWG)
Discussion in the Swiss NWG and foreign NWGs regarding compounding options are currently centered around option 0, 3, and 4, i.e. Plain (in arrears), Lockout Period (in arrears) and Lookback (in arrears).
The general view in the working group(s) is that for RFRs published with one day of delay (T+1), e.g. €STR, the Lookback (in arrears) approach is preferred. The reason is that this technique starts the compounding at least one day in advance of the actual start date and ends at least one day prior to the end date. Since SARON is published on the same day (T+0), the Plain (in arrears) option is theoretically suited best for lending products (e.g. loans and mortgages). The reason is that SARON is calculated and published on the same day, therefore the interest rate payment is known one day prior to the interest payment date. The advantage here is that interest rate payments can be directly charged from the borrower’s account, if the borrower also has a bank account at the lending bank. Nevertheless, the Swiss NWG issued the following main recommendations for banks:
- Institutions should individually define their product strategy given the available guidance on options using compounded SARON.
- Institutions are free to decide whether a floor is incorporated, and at which level the floor is applied. If a floor is part of the contract and the notional remains constant, the floor should be applied to the compounded SARON and not on each individual SARON rate.
- Institutions should liaise with infrastructure providers in order to be ready for banking products with alternative reference rates in various currencies, potentially using different compounding options.
- Institutions should transition CHF LIBOR exposures prior to the end of 2021 wherever possible. Fallback languages should be aligned with the chosen product strategy and include the usage of pre-cessation triggers. A pre-cessation trigger refers to an event to switch to the fallback solution, which is at a point when LIBOR is not ‘representative’ anymore (before LIBOR ceases publication).
With respect to the syndicated loans, the NWG recognizes that cash flow certainty is only needed for a short period. For this reason, the NWG suggests the Lockout Period and Lookback techniques to be used for such loans. Moreover, the NWG recommends using the Lookback techniques with an offset of 5 business days in the swiss market. Nevertheless, since financial institutions may need different offset periods given either borrower/lender needs or consistency among currencies, an offset period of 3 to 5 business days might be feasible too.
For very short-term loans or loans having interest period shorter than the offset period, other techniques as Last Recent (in advance) can be used. Finally, with respect to the corporate lending, the NWG suggests the used of compounded SARON calculated with the Plain (in arrears), Lookback (in arrears) or Payment Delay (in arrears) technique.
FINMA “Dear CEO letter”
The Swiss Financial Market Supervisory (FINMA) has written a new “Dear CEO letter” to 26 banks and securities firms having the highest pstr-2021 LIBOR material exposure. The recipients encompass the 99.8% of the LIBOR exposure with maturity after 2021, based on the 2019 self-assessment. Moreover, FINMA recommends all firms impacted by the IBOR transition to comply with FINMA’s expectations, e.g. progress in replacing CHF LIBOR-based by SARON-based cash product within end 2020, action in issuing new products based on alternative reference rates and further actions in testing IT systems, models and tools. Finally, FINMA expects the definition and implementation of a clear strategy to “avoid damage from reputational and legal risk” which include internal instructions for a correct approach towards clients. Therefore, a development of a training program and relevant guidelines on LIBOR replacement for employees results necessary.
Market development on compounded SARON
Swiss Infrastructure and Exchange (SIX) has provided the formula for calculating a compounded SARON with allowing non-business days as start and/or end date too. Moreover, SIX is providing a calculator to reproduce the SARON compounded rate for a specific interest period, as well as working on a free web-based solution of that calculator which will be available by August 2020.
In February 2020, the Glarner Cantonal Bank initiated SARON-based mortgage contracts using 3-months compounded SARON based on the Lookback (in arrears) technique with a shift of 5 days (plus a client margin). In case the 3-month compounded SARON turns out negative, the margin is added onto a 0% floor. The bank most likely preferred the Lookback (in arrears) over the Plain (in arrears) technique due to operational cash management practicalities as well as simplicity and understandability of the mortgage product for the client. For more insight in client pricing of these new mortgage contracts, see Figure 1.
Figure 1: Client pricing of SARON-based mortgages. Source: Glarner Kantonalbank, factsheet Die Rollover-Hypothek.
Figure 1 provides insight into the relationship between SARON and the client rate of SARON-based mortgage contracts. The margin is applied onto a base rate, which follows the SARON market rate over time in a stepwise manner. When SARON is below 0%, a floor on the base rate is applied.
In May 2020, other Cantonal Banks issued their own SARON-based mortgages. St. Galler Cantonal Bank issued the “SARON-Hypothek” (i.e. SARON-based mortgage) with the same features as Glarus Cantonal Bank, i.e. mortgage contracts using 3-months compounded SARON based on the Lookback (in arrears) technique with a shift of 5 days (plus a client margin). In case the 3-month compounded SARON turns out negative, the margin is added onto a 0% floor. Luzerner Cantonal Bank is also using the Lookback (in arrears) technique (plus a client margin), but the shift is only 2 days. On the other hand, UBS Switzerland AG proposes the Lockout (in arrears) technique, with 1 day of lockout period and with the margin added onto a 0% floor in case of negative 3-month compounded SARON. Zurich Cantonal Bank has set his margin to 1.04% for both the 1 month and 3 months rollover period. On the other hand, Credit Suisse AG is providing an in advance solution based on the Last Reset technique, beside the most common in arrears compounding option.
Table 1 – Summary of the techniques used by each bank with compounding option, technique, and shift/lockout days.
The consequences of banks choosing different compounding options and techniques are that (a) clients have more difficulties to understand the products and (b) clients have more difficulties to compare the products among banks.
*The technique and shift/Lockout days were not explicit on the Credit Suisse AG webpage on date 26.06.2020
The transition from IBOR to alternative reference rates affects all financial institutions from a wide operational perspective, including how contracts are written and priced. Existing LIBOR-based contracts with maturities beyond December 2021 need fallback provisions, due to the discontinuation (cessation) of the LIBOR rates after 2021. Robust fallbacks must be adopted to reduce the risk of serious market disruption and market participants finding themselves in disagreement or dispute on rights and obligations attached to these LIBOR-based contracts. In the next installment, IBOR Reform in Switzerland – Part IV, the fallback provisions from a theoretical and empirical prospective will be explained in more detail.
For more information about the challenges and latest developments on SARON, please stay in touch with Zanders Switzerland: Martijn Wycisk or Davide Mastromarco.
The other articles on this subject:
Transition from CHF LIBOR to SARON, IBOR Reform in Switzerland, Part I
Calculation of compounded SARON, IBOR Reform in Switzerland, Part II
Fallback provisions as safety net, IBOR Reform in Switzerland, Part IV
 Mastromarco, D., Wycisk, M. Calculation of compounded SARON. IBOR Reform in Switzerland – Part II. May 2020.
 National Working Group on Swiss Franc Reference Rates. Discussion paper on SARON Floating Rate Notes. July 2019.
 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.
 National Working Group on Swiss Franc Reference Rates. Starter pack: LIBOR transition in Switzerland. December 2019.
 Financial Stability Board (FSB). Overnight Risk-Free Rates: A User’s Guide. June 2019.
 ISDA. Supplement number 60 to the 2006 ISDA Definitions. October 2019.
 ISDA. Interbank Offered Rate (IBOR) Fallbacks for 2006 ISDA Definitions. December 2019.
 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.
 Glarner Kantonalbank. 02/2020. Die Rollover-Hypothek – günstig & flexible, Neu auf SARON®-Basis.
 St. Gallen Kantonalbank. 05/2020. SARON-Hypothek.
 Luzerner Kantonalbank. 05/2020. SARON®-Hypothek. Das neue geldmarktbasierte Finanzierungsmodell für Kreditnehmer […].
 UBS Switzerland AG. 0/42020. More flexibility. The UBS SARON Mortgage – the unlimited, variable-rate mortgage with an attractive Swiss base rate.
 Gemeinschaft. Mehrwert. Bank. 05/2020. Geldmarkt-Hypotheken.
 Raiffeisen Schweiz Genossenschaft. 04/2020. SARON Flex-Hypothek.