Thursday, 14 January 2021

CME steers away from ISDA fallback

Since the discussion related to the fallback have started almost three years ago, our opinion has been that the methodology proposed, in particular by ISDA, based on compounded in arrears are unsatisfactory. The compounded in arrears itself is the correct approach for overnight, but forcing an overnight in-arrears mechanism into instruments designed for term in advance rates can only lead to dangerous situations from a risk management perspective.

Marc has been quite vocal about it in his blogs and technical publications. The earlier warning can be found in his quant perspectives (proposal, July 2018 and results, January 2019) and blogs (e.g Fallback compounding in arrears won't work).

Recent presentation to clients included in particular messages like:

Don't sign the protocol, don't go through the fallback, this is a unmanageable Frankenstein.

Our advise, in the same presentation was

Fallback does not create OIS-like exposures. Better to repaper existing LIBOR swaps to OIS (even if with same spread).
muRisQ Advisory presentation to a client on 17 December 2020.

There was a general believe that CCP would adopt the ISDA protocol. But in the same client discussion we said: "CCPs do whatever is the easiest for them, not what is right for the market. We still have to read the details of the CCP fallback"!

CCPs have full discretion on how to incorporate fallback.
muRisQ Advisory presentation to a client on 17 December 2020.

We invite you to (re)read of previous blog related to the reason why the proposed ISDA fallback is not acceptable in term of risk management: Fallback transformers: gaps and overlaps and its portfolio or Christmas versions.

LCH recently indicated that it does not plan to use the fallback, as described in the press and in the blog: LCH plans Libor swap switch to RFRs

CME appears to also follow our lead and suggest not to use the fallback. Today's announcement "Cleared Swaps Considerations for IBOR Fallbacks and Conversion Proposal" offers a very short overview of the conversion direction.

The discussion document ask about timing, calculation periods, coupon payment dates, and swaption exercise. Those issues have been mainly ignored in previous consultations and in the collateral/discounting big bang.

We have provided in detail analysis of all those issues to several clients, buy side and sell side. The analysis are all based on production grade code implementing all the successive versions of the fallback, including all the timing, dates and spread issues. Hopefully detailed independent analysis of those issues will be performed and made public by the CCPs.

Don't fallback, step forward!

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