ISDA Consultation on IBOR fallback: GBP impacts

The results of the final consultation on parameters and tenors had been published on Friday 15 November 2019. The decision is to use "historical median approach over a 5-year lookback period" with "two banking day backward shift adjustment period".

Based on the median and 5-year lookback period, we have recomputed our estimations for the LIBOR-SONIA spreads in GBP. The two graphs below are for the LIBOR-3M and the LIBOR-6M. The LIBOR-6M/SONIA spread is obtained by combining the more liquid LIBOR-6M/LIBOR-3M and LIBOR3M-SONIA spreads.

The graphs contain the historical data for LIBOR-SONIA basis swaps with a tenor of 30-year (dark blue line) and with a tenor of 1-year (light blue line). The vertical red lines correspond to the consultations important dates: start of the first consultation in July 2018, publication of the results of the first consultation on 26 November 2018, spread consultation start on 19 September 2019 and the spread consultation results on 15 November 2019. Both the LIBOR-3M and LIBOR-6M spread to SONIA have moved considerably after Friday's results.

The grey lines represent the estimates of historical spreads using different methodologies. Between the first consultation results and the spread consultation publication, we have used 5, 7 and 10-year periods and both median and mean (light grey) in all cases with different announcement dates. Between the the spread consultation publication and its results, only two scenarios were still under discussion: the 10-year period with mean (middle grey) and the 5-year period with median (dark grey). From Friday onward, only this last scenario is still of interest.

Figure 1: Market (1-year and 30-year) and historical spread for LIBOR-3M/SONIA.

Figure 1: Market (1-year and 30-year) and historical spread for LIBOR-6M/SONIA.

We can see that in both cases, the market spread for 30-year tenor moved to the 5-year period median values. The market spread for 1-year tenor seems unaffected. From our computations, we see still some room for the LIBOR-3M/SONIA spread to narrow by a couple of basis points.

All the figures above are for cleared swaps. The impacts on uncleared swaps need to be reviewed separately.

IBOR Fallback status for different products:

We have proposed many detailed technical documents related to the IBOR fallbacks. Beyond those important details, one overview question reappear on a regular basis: what is the status for the different vanilla products (cleared and uncleared).

Below is our summary answer.

First a couple of definitions:

ISDA new fallback: compounding setting in arrears with 2 days composition period shift and historical median over 5-year lookback period.

CCPs new fallback: ISDA new fallback, once and how adopted by the CCPs (small variations possible).

New trades: Trades done after the introduction of the new definitions (expected in 2020).

Vanilla IBOR swaps

• Cleared
• Legacy and new trades: CCPs new fallback
• Uncleared
• Legacy trades: Current fallback no fit for purpose, possibility to sign protocol to use ISDA new fallback. Cost of signing the protocol to be determined (see short story and Quant Insights 2019 presentation). New fallback changes the forward rates (fixed spread).
• New trades: ISDA new fallback.
• Note: For some almost vanilla swap, like IMM swaps, the ISDA fallback is not achievable for all coupons, even with the 2-day composition period shift. For those trades (legacy and new), fallback to be agreed bilaterally.

FRA

• Cleared: New ISDA fallback not fit for purpose, fallback at the sole discretion of the CCPs, no mechanism proposed yet.
• Uncleared:
• Legacy and new trades: New ISDA fallback not fit for purpose, to be agreed bilaterally.
• Alternative: Physical settled OIS (see description here)

Cap/floor

• Cleared: not cleared at any CCP
• Uncleared:
• Legacy trades: Current fallback no fit for purpose, possibility to sign protocol to use ISDA new fallback. Cost of signing the protocol to be determined. New fallback changes the forward rates (fixed spread) and the option type (European to Asian)
• New trades: Asian options instead of European
• Alternative term sheet for new trades (potentially for legacy trades with a new protocol): European options with physical settled OIS (see description here)

Swaptions

• Cleared: Short term optionality at CME, very illiquid. CCPs new fallback.
• Uncleared
• Physical delivery of a cleared swap: CCPs new fallback.
• Cash settlement: No fallback for the ICE swap rate, currently no solution. Note that cash settlement with collateralised price is impacted by the change of discounting mechanism at CCPs in 2020.
• Alternative: Change cash settlement with collateralised price to physical settlement at CCP. Require assessing the impact on valuation (forward, volatility, discounting).

ED futures and options

• CME: Fallback to SOFR futures, generally in line with the ISDA fallback for swaps (compounding and spread). Difference on the underlying period (IMM v LIBOR 2 days shifted). Some comments here.
• Other CCPs: no official proposals yet

 

Deliverable swap futures

• No official proposal yet
• Alternative: Create OIS risk-based futures (as proposed in white paper Risk-Based Overnight-Linked Futures Design).

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Don't hesitate to contact us for more details on our research and tools related to the LIBOR fallback for OTC and ETD derivatives.

CME ED futures fallback

CME as published the general description of the planned fallback for Euro-dollar futures and euro-dollar options.

At a high level, CME plans to copy the ISDA fallback methodology, replacing the forward looking LIBOR by a backward looking SOFR composition and a fixed spread. The spread will be the same as the one computed according to ISDA planned new definitions. If the goal is to mimic the ISDA new definitions, it appears to us that the CME proposal is a good methodology ... in theory.

As always, the devil is in the details. Among those details are the convexity adjustment (already described in the working paper Overnight Futures: Convexity Adjustment, February 2018. Available at SSRN: https://ssrn.com/abstract=3134346) and the difference in volatility between LIBOR and OIS (Hybrid Model: A Dynamic Multi-Curve Framework, August 2018. Available at SSRN: https://ssrn.com/abstract=3237403).

Another detail that was briefly touched on in the CME webinar is the difference in period on which the rates are computed for LIBOR futures and SOFR futures. To which we have to now add the 2 business day shift in ISDA OTC LIBOR fallback.

In practice what is the magnitude of those "period adjustments"? This is one of the elements we have looked at in our analysis of the transition. The table below reproduces the disparities in days using the SOFR futures as base and the ED futures and OTC theoretical compounded in-arrears (under the hypothesis that the LIBOR period is used as reference for the in-arrears computation). We have simply displayed the figures for 2022.

Futures month	OTC start	ED end	OTC end	ED length	SOFR length	OTC length
Jan-22	-5	-1	-6	90	91	90
Feb-22	-2	-2	-6	89	91	87
Mar-22	-2	1	-1	92	91	92
Apr-22	-2	0	-2	91	91	91
May-22	-2	1	-1	92	91	92
Jun-22	-2	-6	-8	92	98	92
Jul-22	-2	1	-1	92	91	92
Aug-22	-2	1	-1	92	91	92
Sep-22	-2	0	-2	91	91	91
Oct-22	-2	1	-1	92	91	92
Nov-22	-2	1	-1	92	91	92
Dec-22	-2	6	2	90	84	88
Min (2020-2031)	-5	-6	-8	89	84	87
Max (2020-2031)	-2	6	2	92	98	95

As can be seen, the OTC start date can be between 2 and 5 days before the SOFR futures start date. The end between SOFR and ED futures is anything between -6 and 6 days. The end between SOFR futures and fallback OTC is anything between -8 and 2 days. You can also see the differences in term of accrual period length.

Obviously those difference in length means a different hedging efficiency between the current LIBOR framework and the after fallback SOFR framework.

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The code used to produce the table above can be found (open source) on the GitHub marc-henrard/analysis repository at https://github.com/marc-henrard/analysis/blob/master/src/analysis/java/marc/henrard/analysis/fallback/FallbackEurodollarFuturesDatesAnalysis.java

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Don't hesitate to contact us for more details on our research and tools related to the LIBOR fallback for OTC and ETD derivatives.

Final parameters fallback consultation results - updated transformers

The results of "The Final Parameters Consultation" have been published by ISDA on 15 November 2019. The fallback will be based on "historical median approach over a five-year lookback period" with "two banking day backward shift adjustment period".

We have updated our "LIBOR fallback transformers" code to include the new fallback options introduced by the consultation. Now the choice of fallback extends to the compounding in arrears with two days shift on the IBOR period or two days shift on the calculation period.

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Don't fallback, step forward!

Contact us for LIBOR fallback and discontinuation: trainings, workshops, advisory, tools, developments, solutions.

Interest Rate Reform Conference: LIBOR transition workshop

Marc Henrard will present a workshop at

Interest Rate Reform Conference.

The workshop will take place on Wednesday 4 March 2020 in London. The details of the workshop can be found on the organizer web site:

Benchmarks and LIBOR transition: Quantitative Perspective on Benchmarks, Overnight, Libor Fallback and Regulation.

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Workshop's overview: 

With the increased expectation of some IBORs discontinuation, the overnight benchmark changes and the increasing regulatory requirements related to benchmarks, a clear quantitative finance perspective on the impacts for benchmark-linked derivatives is becoming paramount. The recent regulations include the EU Benchmark Regulation (BMR) which will have a severe impact on the EUR market from January 2022. For all major currencies, new benchmarks have been proposed and the market are in a transition phase. Each transition has his idiosyncrasies and a common transition approach cannot be expected. On the EUR side, a recalibration approach with clean discounting has been proposed for EONIA. This has happened on 2 October 2019. This changes have potentially important value transfer impacts. On the fallback side, several options have been proposed and ISDA is holding consultations on some of them. The results of the first ISDA consultations has been to select the ``compounding setting in arrears" adjusted rate and the "historical mean/median" spread approach. We present those options and emphasise their drawbacks. In particular the compounding setting in arrears lack of details and, in the words of ISDA, is not workable for some products. We also present alternative options supported by different working groups. The historical spread option can lead to significant value transfer, some of them having already taken place. The latest consultation on fallback parameters and tenors finished in October, new value transfers have been observed. We present historical data is several currencies to support the theoretical developments. The presentation focuses is on the quantitative finance impacts for derivatives. On top of this, CCPs have announced their transition plan from the current ON benchmarks (Fed Funds and EONIA) to the new ones (SOFR and ESTR). More opportunities to make or lose money if you understand the fine quantitative details of the transition or not.

Graphical representation of elements of my personal filtration related to the fallback.

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The workshop is also offered as an in-house program tailor-made to your exact requirements in term of content and schedule.

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Don't hesitate to reach out if you want to meet at Interest Rate Reform Conference or discuss our services.

Change in collateral rate at CCP: quant perspective

CCPs have announced that they will change the PAI/collateral rate in USD from Effective Fed Fund rate (EFFR) to SOFR. This will be done as a big bang approach, not in line will the planned paced transition set by ARRC in 2017. The planned date for the big bang transition at CME and LCH is Friday 16 October 2020. Some description for CME can be found on their website; we have not found a similar description for LCH, even if it appears that the methodology will be similar.

Such a big bang approach does not offer the "choice between clearing swap contracts into the current PAI/discounting environment or one that uses SOFR for PAI and discounting" as planned by the ARRC. The change is forced on market participants at a price and with a methodology selected by the CCPs.

Such an approach creates the opportunity for value transfer between market participants and may generate unintended consequences. We have detailed some impacts, potential consequences and open questions in a technical document now available freely on a preprint server.

The document, in the muRis_Q Advisory Market Infrastructure Analysis series, is titled

SOFR discounting transition: multi-curve and quantitative perspective.

and is available on SSRN with the reference

Henrard, Marc P. A., SOFR discounting transition: multi-curve and quantitative perspective. Market Infrastructure Analysis, muRis_Q Advisory, October 2019. Available at SSRN: https://ssrn.com/abstract=3478769.

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Added 23-Nov-2019: The code used to create some of the PV01 reports is available (open source) on the marc-henrard/analysis Gitbub repository: https://github.com/marc-henrard/analysis/blob/master/src/analysis/java/marc/henrard/analysis/product/overnighttransition/SofrPaiTransitionSensitivityAnalysis.java