Tuesday 21 January 2020

Signing the LIBOR fallback protocol: a cautionary tale

As Orwell's Room 101 beckons for LIBOR publication, muRisQ Advisory's Marc Henrard warns of potential pitfall in the fallback protocol.

This is the Risk.Net introduction to Marc's comment about the cleared/uncleared fragmentation of the market due to the design of the IBOR fallback.

The full text is available on Risk.Net website (subscription required):

Figure from the above published comment.

Note that the issue of the market fragmentation will be particularly visible in EUR where it is expected that EUR-LIBOR will be discontinued at the end of 2021 and EUR-EURIBOR will continue to exist probably for a further 5 years. It appears that the EUR-LIBOR fallback will be done directly to ESTR and not to EUR-EURIBOR as suggested in our answer to the ISDA EUR fallback consultation. Any payment originating from LIBOR fallback will be easy to compare to an actual EUR-EURIBOR payment (see also the post about the EUR curve shape not in line with ISDA fallback at all).

The discrepancy between fallback contaminated and clean versions of LIBOR payments should be taken into account in bond reference rate switch from LIBOR to SONIA. A popular method seems to infer the adjustment spread for bonds from the swap market as reported in Nationwide and Lloyds win nod for Sonia bond switch (subscription required). But those spreads are based on the historical past spread, not on the forecast of actual LIBOR-like value. Obviously the switches have been done with the approval of the note-holder, but was that approval based on a clear understanding by the note-holders of what was behind those contaminated cleared swap market figures?

Saturday 18 January 2020

Answer to ISDA consultation on EUR-LIBOR and EUR-EURIBOR fallback

ISDA consultation regarding EUR-LIBOR and EURIBOR fallback closes in a couple of days. As for the previous consultation, we have provided a detailed answer. The text of our answer can be found on SSRN: Answer to ``Supplemental Consultation on Spread and Term Adjustments, including Final Parameters thereof, for Fallbacks in Derivatives Referencing EUR LIBOR and EURIBOR, as well as other less widely used IBORs'' issued by ISDA  http://ssrn.com/abstract=3520619.


The consultation is based on question similar to the previous consultations. The answers we provided to those consultation and the quantitative literature related to the same subject can be used to understand why the proposed solutions are not acceptable.

To those generic answer, there are two EUR specific issues that should be emphasised. The first one is positive and is the existence of two benchmarks (EUR-LIBOR and EUR-EURIBOR) with one of them expected to outlast the other by several years. The surviving benchmark should be used as the first step of the fallback for the other benchmark. The second issue is negative and is due to the fact that the planned fallback benchmark, ESTR, has been published only since 1 October 2019. Data preceding that date are for some part not intended for use as benchmark by the administrator and regulator and for the older part not regulation compliant. The only ESTR data acceptable is the one officially published as a benchmark, i.e. data for dates after 1 October 2019.

We suggest once more to ISDA to fundamentally review the decision to base the fallback on the compounding setting in arrears and historical mean approaches.

The answer should be read in conjunction with our previous answer and publication, including a couple of paper in peer reviewed journals.

Answer to``Consultation on Certain Aspects of Fallbacks for Derivatives Referencing GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW'' issued by ISDA. October 2018.
Available at http://multi-curve-framework.blogspot.com/2018/10/isda-consultation-on-libor-fallback-my.html.

LIBOR Fallback transformers! 
Market Infrastructure blog, muRisQ Advisory, October 2018.
Available at https://murisq.blogspot.com/2018/10/libor-fallback-transformers.html.

A Quant Perspective on IBOR Fallback consultation results.
Market infrastructure analysis, muRisQ Advisory, January 2019.
Available at http://ssrn.com/abstract=3308766.

Answer to ``Supplemental Consultation on Spread and Term Adjustments for Fallbacks in Derivatives Referencing USD LIBOR, CDOR and HIBOR and Certain Aspects of Fallbacks for Derivatives Referencing SOR'' issued by ISDA. July 2019.
Available at https://ssrn.com/abstract=3415930.

Answer to ``Consultation on Final Parameters for the Spread and Term Adjustments in Derivatives Fallbacks for Key IBORs'' issued by ISDA. October 2019.
Available at https://ssrn.com/abstract=3476530.

LIBOR fallback and quantitative finance. Risks, 7(88), August 2019. Open Access article available at https://doi.org/10.3390/risks7030088.

LIBOR: Don't fallback, step forward. Wilmott Magazine, November 2019.

Fallback protocol signature: a cautionary tale. Risk.Net, January 2020, to appear.

The figure is extracted from the post related to the "EURIBOR: The market does not believe in ISDA fallback in the next 10 years!"

Figure 3: Time series of EURIBOR and (pre-)ESTR compounded with 6-month underlying period.

Thursday 16 January 2020

Marc's workshop at QuantMinds International 2020

Marc Henrard will present a workshop and a seminar at

QuantMinds International

which will take place from Monday 11 May to Friday 15 May 2020 in Hamburg. The agenda of the conference can be found on the organizer web site:

Marc's workshop, will take place on Friday 15 May and will be titled Benchmarks in transition: Quantitative perspective on benchmarks, transition, fallback and regulation..

The workshop agenda can be found on the organizer website at https://informaconnect.com/quantminds-international/ibor-workshop/

The workshop can also be run as an in-house course tailor made to your needs as described on our training page related to benchmarks.

We will add the details of the talk closer to the date. 

Don't hesitate to reach out if you want to meet during the conference.

Saturday 11 January 2020

Marc's presentation at the Quant Summit Europe 2020

Marc Henrard will present a seminar at the

Quant Summit Europe

which will take place on Wednesday 11 and Thursday 12 March 2020 in London. The agenda of the conference can be found on the organizer web site:

Marc's talk, will be titled LIBOR fallback: the cost of a signature.

Talk's agenda:
  • ISDA fallback methodology 
  • Value transfer in the fallback 
  • ISDA protocol signature crystallize the value transfer: what is its cost?

As a speaker at the summit, we can offer our guests a 20% discount. Contact us for the discount code.

Don't hesitate to reach out if you want to meet during the summit.

EURIBOR: The market does not believe in ISDA fallback in the next 10 years!

ISDA has launched a couple of weeks ago a new consultation related to IBOR fallback. This consultation is related to EUR-LIBOR and EUR-EURIBOR (and undisclosed other IBORs!). In the previous blogs about the fallback over the last 2 years, we have not provided any figure for EUR. The reason was two fold: we don't really believe in imminent EURIBOR fallback and the EUR rate market has been completely dormant for several years and it is very difficult to read anything in that market.

With the questions about the EUR fallback coming to the fore, it is a good time to try to read something from the market rates.

The conclusion is the title of this post:
The market does not believe in ISDA proposed fallback for EURIBOR in the next 10 years!

The conclusion is intentionally ambiguous. It can be read that the market does not believe that the ISDA proposed fallback methodology will be adopted in the next 10 years or that there will be no requirement for a fallback in the next 10 years, i.e. that EURIBOR will survive that period.

Before explaining the conclusion, we need to describe the data and the premises of the analysis. The data is based on historical ESTR (and pre-ESTR) figures, historical EURIBOR and current basis spread market.

The ESTR benchmark was officially started on 1 October 2019, but ECB has published pre-ESTR figure with values dating back to 15 March 2017. If we include the pre-ESTR figures in the analysis that is almost 3 years of data. Without the pre-ESTR data, there is a little bit more than 3 month of data, this is not enough to compute one single ESTR compounded in arrears for one 6-month period! The pre-ESTR figures are, according to the ECB, not intended for use as a benchmark in any market transaction, whether directly or indirectly", but are acceptable for personal analysis.

With the ESTR data, I have computed the composition on EURIBOR periods 1, 3 and 6 months. The computation is done using the open source code that I have posted in February 2018. The ESTR compounded rates are then compared to EURIBOR and median is computed (using code posted in Marc's Analysis repository: https://github.com/marc-henrard/analysis).

The historical time series of ESTR compounded are represented graphically in the figures below. The full data is also available in the analysis repository described above.

Figure 1: Time series of EURIBOR and (pre-)ESTR compounded with 1-month underlying period.

Figure 2: Time series of EURIBOR and (pre-)ESTR compounded with 3-month underlying period.

Figure 3: Time series of EURIBOR and (pre-)ESTR compounded with 6-month underlying period.

As can be seen in the data, there was very little volatility in ESTR and in EURIBOR and consequently very little volatility in the relevant spreads.

Let's look at the 1-month, 3-month and 6-month tenor spreads against ESTR compounded in arrears. The medians are 7.95 bps, 12.41 bps and 18.06 bps. Those medians are the relevant figures for the ISDA fallback methodology. Those spreads imply a 6-month/3-month basis spread of 5.65 bps.

What is the market saying? Looking at the 10-year tenor basis swaps, we see a spread of around 6.20/6.50 bps. That seems roughly in line with the above computed spread. Two possible explanations for that figure: the market believe in the imminent fallback of EURIBOR to ESTR using ISDA proposed methodology for the spread or this is a coincidence. To decide between the two, let's look a the spread curve shape. If EURIBOR fallback to ESTR + spread in the next 10 years, the fallback being definitive, it will still be there in the 20 following years. What is the 30-year tenor basis spread? The spread is just below 3 bps. A back of an envelop computation give a spread of around 1.25 bps for the 20 years between 10 and 30 years. Definitively the market does not indicate an expectation of the ISDA proposed fallback to apply to EURIBOR in that period.

Maybe we are missing something in the computation. The market may expect the spread implied by the realized LIBOR/ESTR fixings to decline to a small figure in line with the long term quoted spread. But the spread for the 10-year tenor basis swap is around 6.5 bps, the market expect that spread to be realised, so it expect that the spread on the ISDA proposed 5-year look-back spread will be around that figure.

We are oversimplifying the story in the above paragraph. The market 6.5 bps is an average in the risk neutral measure but the historical spread is a median in the historical measure. Can the difference between the two explain the difference? If yes, would it make sense to try to statistically arbitrage this difference?

Another issue is that the ISDA proposed spread is based on realised spreads between forward-looking LIBOR and realized backward-looking compounded ESTR. The spreads contain the credit and liquidity spreads but also the misestimation by the market of the forward looking rates with respect to the backward looking ones. The market may have an estimation of the market misestimation that explain that difference (!).

We are digging quite deep to try to find an explanation. Even if the above explanations are theoretically possible, they seem far fetched. The best explanation seems that
The market does not believe in ISDA proposed fallback for EURIBOR in the next 10 years!

Is it the expectation of a different fallback or the expectation of the EURIBOR to survive for another 10 year? We don't know. We expect EURIBOR to survive at least to 2027 (2022 + 5 year) if a clean transition (including a clean fallback) is not developed in the mean time.

Note: Other long term spreads do not match our computed median spreads:
1Mv3M: historical 4.46 bps - 30Y basis swap 2.3/2.9 bps
ESTRv3M: historical 12.41 bps - 30Y basis swap 8.5/9.1 bps

Maybe there is a way to make money on EURIBOR fallback.