Are LIBOR swaps still representing Interbank credit risk?

The letters "IB" in LIBOR stand for InterBank. The LIBOR fixings are suppose to represent the rate in the interbank market, with its pure interest rate component and its credit risk component. The spread between the LIBOR of a given tenor and the OIS rate for the same tenor can be viewed as a proxy for the credit quality of banks.

In the August to October period, the spread GBP-LIBOR-6M/OIS-SONIA-6M has been between 17 and 19 basis points. From the end of October to today, the spread has increase from 19 basis points to 30 basis points. On the 3M side, the spread had been between 9 and 11 basis points and increased from 11 to 20 basis point in the same two-month period. In the same period the stock market was tumbling (the FTSE 100 lost more than 10% in the same period) and CDS indices spiking. That make sense as there is a high correlation between low stock prices, high credit spreads and higher default rate.

But what happened to the basis spread for 30Y-tenor swaps LIBOR-3M/SONIA during the same period? Nothing! Or more exactly, the spread that was around 22 basis points did not move in November until the 26 of November (announcement of the ISDA consultation preliminary results) where it went DOWN by 3 basis points in two days and has been decreasing slowly since to 18.30 basis points. This is in line with my prediction of the long term LIBOR market not related to the LIBOR itself anymore but to the new expected fallback rules which is backward looking.

The same phenomenon can be observed in USD, with the USD-LIBOR-3M/OIS-FF-3M spread increasing from 25 to above 40 basis points and in the same time the long term 30Y basis swap moving down slowly from 37.5 basis points on 26 November to 31 basis points now.

To summarise: LIBOR spot credit spread significantly up in the last two months in line with equity and CDS markets, long term credit spread in the basis market steadily down to the historical average.


Fallback procedure documents

Four documents related to the IBOR fallback have been published a couple of days ago:
- Anonymized Narrative Summary of Responses to the ISDA Consultation on Term Fixings and Spread Adjustment Methodologies prepared for ISDA by The Brattle Group
- LCH’s position in respect of ISDA’s recommended Benchmark Fallback Approaches
- CME Group Supports ISDA’s LIBOR Fallback Provisions
- Second public consultation by the working group on euro risk-free rates on determining an ESTER-based term structure methodology as a fallback in EURIBOR-linked contracts

Those documents are welcome as they clarify the results of the ISDA consultation and the CCP positions.

I will start with the CCP side. To my knowledge, this is the first time CCPs provide an explicit document related to the fallback. Up to now there were only informal "ISDA is liaising with the CCPs". The content of CCP notes can be summarized as CCPs will adopt the new rules, but reserve the right not to do it and if a CCP changes the rules, they will apply to new and legacy trades. So we can already guarantee a fork in the swap definitions between cleared and uncleared. If the new ISDA rules are not adopted in a CCP rule book, there is an obvious fork for the new trades; if the new ISDA rules are adopted by a CCP, they apply to legacy trades also and there is a fork for the legacy trades.

The ECB working group consultation indicates that some market participants are not happy with the "compounded setting in arrears" and would prefer a derivative based term RFR for the (EURIBOR) fallback. This was the "Option S1" in my answer to ISDA. Another consultation to answer to.

On the ISDA consultation side, I have already express my disappointment at the publication of the preliminary results on the choice of the "compounding setting in arrears" option which is, in my opinion, not achievable. That disappointment was accentuated when I saw that 90% of the respondents are in favour of it. But the same disappointment receded when I reached page 65 / paragraph 178 of the report. That is  the "comments on the implementation" section. That is where the actual details on what the respondents actually mean when they selected "compounding setting in arrears" is hidden. Reading it, I can see what I mentioned: it cannot work as described in the consultation document and some contract term sheet will need to change (FRA in particular) (see the blog where I mentioned changes to term sheets).

The comments include (unfortunately the authors are not indicated in the ISDA document and I cannot credit the authors properly)
  1. "unable to transact certain instruments under the compounded setting in arrears"
  2. "Certain instruments such as FRAs (which pay in advance) would not be able to make use of a fallback where the relevant information was not available until the end of the IBOR period"
  3. "incompatible with the contractual requirements of Forward Rate Agreements (FRAs)"  and "potential mitigating arrangements to cater for these" from a CCP
  4. "As the recent issuance of SOFR-based and SONIA-based FRNs has indicated, determining coupon cash flows on the cash flow date is not practicable." (something I highlighted in my blog on those products)
  5. "situation arises in which the overnight fixing will most likely not be known on the payment date for the IBOR, so the actual value of the IBOR cannot be computed."
  6. "some modification (lock up or backward shift)"
  7. "payment delay" which "must be achieved in a manner that applies consistently to both the IBOR and any derivative that it references."
  8. "have difficulty adopting an alternative RFR without a payment date delay adjustment or a lockout period."
  9. "a compounded [setting] in arrears rate either a short fixing lag or lock-out period."
It seems we need a new consultation to clarify what was the meaning of the option "compounding setting in arrears" in the first consultation. I cannot parody a famous sentence and say "compounding in arrears means compounding in arrears".

The preliminary results ISDA statement indicates that "as part of that decision, the ISDA Board Benchmark Committee will set out the details related to the adjusted RFR and spread adjustment that remain outstanding". The summary of responses referenced above does not help on the details front. As the name indicates, this is a summary of the responses, not a first step in the direction of a clear and detailed proposal. It is based on the number of responses in favor of each option, not an analysis of the quality of each of them.

The search for a manageable fallback procedure continues!


Finance fiction: LIBOR fallback and FIReD

More than 10 years ago, I proposed a (slightly) exotic product that I called Floored Instrument on Rolled Deposit, abbreviated with the eye catching name of FIReD.

If the ISDA Fallback procedure is decided as announced recently with the adjusted RFR based on compounded overnight setting in arrears, my fictional FIReD will become a very common product. All IBOR cap-floors will be on FIReD.

To explain this statement, I need to step back a little bit.


A first version of the working paper describing the details of the product was published in 2005 ( SSRN: https://ssrn.com/abstract=888484). A related article was published in Journal of Risk (Skewed Libor Market Model and Gaussian HJM explicit approaches to rolled deposit options, The Journal of Risk, 9 (4), Summer 2007).

The idea of the product is the following: Money is invested at a given benchmark rate, let say overnight, for a long period with capital plus interest reinvested (compounded) at the end of each benchmark period. Up to now this is similar to a standard cash-account with money left for a long period. But a minimum rate is guaranteed, the return is floored. The floor is not on each of the fixing but on the composition at the end of the product. The original reason to propose such a product was for investments linked to a short rate benchmark (Fed Fund, repo, T-bill, etc.) but for which the investor required a minimal return to pay its expenses.

Cap-floor becoming Asian options

The current proposal by ISDA for the fallback procedure after the preliminary analysis of the consultation is to use overnight compounding setting in arrears. As I have documented in details in my Quant perspective on fallback and in many blogs (here, here, here, here and here), I believe that this approach is not achievable.

But for the sake of interest in my financial fiction, suppose we ignore the non-good business day issue and look at a single caplet. What is the very important difference between an IBOR caplet and a new RFR based caplet after fallback, beyond the change from one benchmark to another? The striking difference (pun intended) is not the strike (spread adjusted) but the exercise date. The actual rate is know only at the end of the period (in arrears), to the dynamic of the rates need to be measured not to the original exercise date but to the maturity date. The rate is averaged (in a special way, called compounding) over the accrual period. The dynamic of the rates between the start date and the end date is important and this importance changes each day. The change of dynamic of the final rate will depend of the number of day left in the period. The vanilla IBOR cap/floor are becoming path-dependent Asian option using compounding as averaging method on rates.


The vanilla IBOR cap/floor are becoming path-dependent Asian options. They become in some sense similar to the futures on overnight as traded on CME, ICE and CurveGlobal, the the optionality changing through the accrual period. For the futures the resulting convexity adjustment is small because the futures expiries are relatively short term. But for cap/floors, we can have maturities up to 30 years and the optionality is a major feature of the product.

Here is an extract from my 2007 paper in Journal of Risk that describe the pricing of the product in a generic HJM model. For the caplets, the n would be the number of (business) days in the IBOR period, i.e. around 60 for a three-month IBOR.

Obviously the formula can be made more explicit in a Gaussian HJM. It becomes:

It is up to the reader to decide if he wants to qualify this product as an exotic derivative or not.

Finance Fiction

This could be the new episode of my series on Finance Fiction. The previous episodes are listed below.

Note that in the first episode, I indicated "For obvious marketing reasons, I do not highlight the proposals that failed to materialize, like options on composition or OIS swaption." Which means that my real mocking of my own fiction is becoming obsolete as more fiction is becoming reality.

Previous Finance Fiction episodes


Update on my Basis position

A quick update on my basis position. I took a position on a basis swap where I pay LIBOR-1M v receive SONIA + spread on a 30-year tenor for a notional of 1m. The spread is at 13.45 bps.

First an update on the different spreads (as of Friday 14 December), with in order, the figure before the announcement, the analysis prediction, the figure on the date I took the position and the figure today

Name Announcement Prediction Position Today
Libor 3M - SONIA 22.50 9 to 18 19.65 19.35
Libor 6M - Libor 3M 5.90 8 to 16 7.60 8.00
Libor 6M - Libor 1M 12.20 14 to 25 13.80 14.20

In all cases the spreads continue in the direction predicted by the analysis.

For my position, there is not a very large movement yet. From 13.45 to 13.15, only 0.3 basis points gained. This is on top of the 2.75 bps that would have been the profit if I had open the position on the day before the announcement. I'm still making a little bit of carry. I will report the exact carry after the first month of the position, when the first coupon is paid.


It is not illegal to be smarter than your counterparties in a swap transaction

"It is not illegal to be smarter than your counterparties in a swap transaction, nor is it improper to understand a financial product better than the people who invented that product."

Richard J. Sullivan
United States Circuit Judge
30 November 2018

This is an interesting statement from the judgement in the United States in the case "CFTC versus Wilson and DRW" (full text available here).

The text of the judgement provide a (surprisingly?) good explanation of derivatives market, including convexity effect on futures. The judgement relates to IDEX 3-month futures. Those futures are not traded anymore since 2011. The text includes consideration about variation margin, basis risk, PAI, convexity adjustments, and futures design.

The background is a badly designed swap futures where some participants notice the bad design and its implications while others didn't. The marketing of the futures claimed that "IDEX IRS futures are designed to be economically equivalent in every material respect to plain vanilla interest rate swap contracts currently traded in the OTC derivatives market" (see marketing flyer here). The "economically equivalent" had to be taken with a poetic license, some market participants (and the clearing house) took it at face value to some extend.

CFTC was suing DRW for biding in this very illiquid market at a price closer to the DRW estimated fair value than the unadjusted OTC swap price. As DRW was the only bidder in this illiquid market, DRW was actually the daily settlement price maker.

My comments are not about the manipulation case but about the futures design. Bad designs of swap futures are dangerous in a market with trillions notional underlying. If you are planning to trade those products, don't take marketing and "every body is doing this" at face value, specially in the flow/linear products interest rate market. Analyze all the facets of the product, including cash flows, settlement mechanisms, regulation, margin (variation and initial), convexity adjustment with respect to other flow instruments, comparison with liquid products, hedging strategies, etc. Innocuously looking effects may have a large value in markets with huge notionals. If you are an exchange planning to launch a contract, get independent opinion or advice from experts, don't be seen as someone who don't understand its own products as well as its clients.

I have proposed a swap futures design that is very close to the OTC market in quotation mechanism and convexity adjustments: see my blog post and detailed technical note.

When you deal with new products and related markets, choose your experts well. Make sure he understands the market your are trading in from inside and all the details of its functioning. Do not choose one of which your shareholders (or a judge in the case described above) could say that his "assertions [are] absurd", as the CFTC did.


Has value transfer in LIBOR fallback started?

In my previous blog, I indicated that I was surprised by ISDA decision to use ‘historical mean/median approach’ for the spread adjustment. I also indicated that this fallback method will create some value transfer between the different sides of the existing trades. To my opinion, that value transfer will not take place at the discontinuation announcement date but at the fallback methodology announcement date, which is now.

The full details of the exact spread computation methodology have not been announced yet, but we can already check some ballpark figures. I have looked at the GBP figures. The reason is that in USD there is no historical data for SOFR (not the multi-year history required by the methodology) and no liquid SOFR-OIS trading and in EUR, the new benchmark is not even published yet.

I start with the LIBOR-3M/SONIA spread has this is the most liquid SONIA spread in trading. My analysis start from the hypothesis that the LIBOR will be discontinued on 1-Jan-2022. The analysis could be adapted for other discontinuation dates. I have computed the historical spread for LIBOR-3M v SONIA-compounded-in-arrears-over-3M (using historical data for the benchmarks, all correct market conventions, holidays, dates, etc.). Which history should be used? The proposed periods in the consultations were 5 and 10 years. Let's take 10 years to start. The 10-year period is from the discontinuation announcement. For simplicity, I take 1-Jul-2021 for that date, which leave a 6-month period between announcement and actual discontinuation. I don't know yet what will happen between now and Jul-2021, but I have already a good view of the mean as I have almost 7 years of the 10 years. And the mean number I get is 17.40bps.

Figure 1: GBP-LIBOR-3M and SONIA compounded-in-arrears over a 3-month period. Spread and historical mean.

Where is the LIBOR-3M v SONIA basis trading today for a 30Y tenor? It is at 19.65 bps. And where was it before the methodology announcement? It was at 22.5 bps. Out of the 5 bps decrease forecast by my simple analysis, 3 bps have been gained in a week.

Luck or skills? Let's see other spreads. Another liquid spread is the LIBOR-6M v LIBOR-3M. The average historical spread (using the same method as above): 15.40 bps. The market 30Y basis spread is at 7.6 up from 6.0 before the announcement. Note that the level 7.6bps is the highest level over the past 3 years. That is two out of two.

For the LIBOR-6M v LIBOR-1M, the average historical spread (using the same method as above): 25.00 bps. The market 30Y basis spread is at 13.8 up from 12.1 before the announcement. Note that the highest level over the past 3 years was 14.2. That is three out of three.

I don't know yet the exact technical details that will be proposed for the spread computation: appropriate length of the look-back period (5 or 10 years), look-back period based on IBOR fixing date or maturity date (due to in-arrears), mean or median, holidays (the overnight benchmarks may not have the same good business days than the IBORs), rounding, cut-off days, etc. So there is still some range for the known part of the spread and there is certainly also some uncertainty about the future values of the fixings (between now and discontinuation announcement).

I have run several scenarios for historical data. For the LIBOR-3M v SONIA, I have a range of spreads from 9 to 18 bps; for the LIBOR-6M v LIBOR-3M, from 8 to 16 bps and for LIBOR-6M v LIBOR-1M, from 14 to 25 bps. All the scenarios are in the same direction with respect to the current basis spread market for long tenors. In all cases, in the last week, the market has moved in the direction indicated by the above analysis. In all cases the market has moved to the be very close to one of the bound of the ranges indicated above. In two cases out of three, the basis spread is near its maximum over the last 3 years.

The question in the title was: Has value transfer in LIBOR fallback started? It looks like the answer is: Yes.

Can we still make money out of it? That is more difficult to say at this stage. But I will take a (paper) position based on the above analysis: I enter into a basis swap where I pay LIBOR-1M v receive SONIA + spread on a 30-year tenor for a notional of 1m. The current spread is at 13.45 bps. My analysis gives me a 4 to 8 basis points range for the fallback spread. I expect that the market will settle on an estimate of the fallback spread within one year. The horizon for my position is 29-Nov-2019. Target profit is 5bps x ~2000 GBP/bps = ~10,000 GBP. I cut the position on the earliest of when the market has reached 8.5 bps or on 29-Nov-2019. I'm also expecting a little bit of carry as the current level of realized spread (1 to 3 bps) is below the market basis spread.

See you on 29-Nov-2019 for the result!

Feel free to contact me for analysis in other currencies or to discuss positions to could take advantage of the fallback.

Edit 2-Dec-2018: I have started to add the code used for this blog in my open sources muRisQ Libraries. The computation of the composition is available at https://github.com/marc-henrard/muRisQ-ir-models/blob/master/src/main/java/marc/henrard/murisq/pricer/generic/FallbackUtils.java. I will add the code that I used for the graphs and average computations at a later stage.


ISDA published Preliminary Results of Benchmark Consultation

ISDA has published Preliminary Results of Benchmark Consultation.

As expected, the majority of respondents preferred the ‘compounded setting in arrears rate’ for the adjusted risk-free rate (RFR). This is to my opinion an error, as detailed in my Quant Perspective. The proponent of the method have not yet detailed how it would work in practice for instruments that require an immediate settlement (FRA, IBOR in arrears, range accrual, etc.; a minority of trades but not a small amount) and vanilla instruments with non-good business day adjustments (the majority of trades).

The ISDA statement indicates that "as part of that decision, the ISDA Board Benchmark Committee will set out the details related to the adjusted RFR and spread adjustment that remain outstanding". Hopefully, the details related to the dates question I have mentioned in my answer to the consultation will be provided.

The second part of the consultation provided an answer that I was not expecting. The spread adjustment option selected by the majority is the ‘historical mean/median approach’. The big advantage of the methodology is that it is simple, with little possibility to manipulate (would require to manipulate the past 5 or 10 years) but its big disadvantage was that it would create a value transfer at discontinuation. The value would have changed from the expected economic difference between the future value of LIBOR to the average of the past. I used the past and conditional in the above sentence for the following reason.

By deciding the use an historical average, the transfer of value is still present but at a different moment. The value transfer is not anymore at the discontinuation announcement date but at the fallback methodology announcement date. We expect the discontinuation for LIBOR to happen in 2021, in 3 years time. We don't need to look at the economic reality of LIBOR-OIS spread (bank credit risk) anymore to price a LIBOR-OIS spread for any fixing beyond 2021. The only thing that is important is the past 7 years and the next 3 years (to obtain a 10 year history), not the reality at the fixing date. The value transfer took place when the fallback option was decided. The value transfer will not be seen immediately as the market has to absorb the information and the different participants have to incorporate it in their anticipations.

Unfortunately I don't have access to detailed market data about basis in the different currencies to do an in depth analysis. But it would be interesting to see how much the long term forward basis (beyond 2021) in the LIBOR related currencies have changed to be close to the historical mean over the last months, since the publication of the consultation and the reception of its answers.


A two cent arbitrage - free options

Mandatory arbitrage

Belgium is now imposing mandatory arbitrage in retail. I concede that this is a 2 cents (0.02 EUR) maximum arbitrage by transaction, but an arbitrage nevertheless. The arbitrage is imposed on retailer by forcing them to issue free option with each retail transaction. There is no limit to the number of transactions by customer and retailers cannot refuse the transaction (and the arbitrage).

The mandatory free option was proposed by a Belgium vice-premier and minister of Economy (Kris Peeters; one of the top 5 minister in Belgium) and approved by the Council of Ministers.

Obviously the minister press release does not describe his decision like I did. It is presented as a simplification measure without impact. The press release even indicate that "on average the consumer will pay the same amount". According to the press release, the ECB shares the analysis (I would like to see the analysis). The press release (in French) can be found here:
http://www.krispeeters.be/sites/default/files/20181123_CP_Arrondissement_paiements_cash.pdf (I'm still looking for an official document, not only a press release on the personal website of the minister).

Arbitrage origin

Now I need to explain where this issue is coming from. The official smallest currency amount in Euro-land is one cent (0.01 EUR). This is a very small amount. The production and handling of the 1 cent and 2 cents coins have a large cost. The idea is then to leave the official smallest amount to 1 cent but change it in practice for actual payments to 5 cents (the third smallest coin) by a rounding mechanism. The rounding is not apply on the price for each item but on the price for each purchase of multiple items. Currently the rounding is not mandatory but can be decided by the retailer. To my knowledge, there is no obligation for the retailer to indicate to the customers if they apply the rounding option before the total price is indicated to the customer. It seems that the retailers have today the free option to chose the rounding or not and that they can do so for each purchase. In practice, very few retailers use the rounding free option, because they are afraid to be seen taking advantage of the system and somehow getting a bad reputation.

The proposal by the minister is to impose a mandatory rounding, but only for the cash payments, not the card payments. Now the option is inverted and there is no need of the customer to loose face or reputation by indicating explicitly his rounding choice. If the total price of his purchases is ending by 1, 2, 6 or 7 cents, pay by cash and get a 1 or 2 cents discount. If the total price ends by 3, 4, 7 or 9 cents, pay by card and pay the exact price. In case of 0 or 5, do whatever is most convenient. So exercise your free rounding option, not by saying explicitly that you do it, but by exercising your cash/card option (which would be value neutral otherwise). You can be greedy without saying it.

On the other side, you have to weight the 1 or 2 cents arbitrage with the potential inconvenience of checking the final price and having enough cash with you to exercise the option.

Exercising your free option

On my side, I plan to use this option (at least once ;)). It would be funny to see a lot of people using that option. The impact would be (small) financial losses for the retailer, probably larger losses in term of operational cost. More cash transactions, less self service teller used (if they don't have cash option).

This is the risk of having a economy minister that is not a quant (he is a lawyer and accountant by background). He is also in charge of "financial products" and financial regulators (FSMA), two good reasons to have a quant or at least a quant aware person at that position or in last resort having a quant advisor (in the list of his many advisors, I don't see any "financial products" or "financial regulation" advisor). He can create, probably out of good will, unintended quantitative finance consequences from qualitatively looking innocuous decisions. Like for all regulatory proposal related to finance and economy, I would encourage regulators and law makers to consult with quants on the quantitative impacts. Some conséquences may be unintended but most of them are certainly not un-forecastable. (I'm available for consulting engagements if needed).

Having fun

The new law related to the rounding will take effect only on 1 December 2019. So I will need to wait another year before being able to test my arbitrage. It would be fun (at least for some meaning of fun) if on that date everybody was exercising its free option and take advantage of the possibility. We could call it the "quant awareness day". Nowadays, there are "awareness day" for almost everything (see for example https://www.awarenessdays.com/) why not for quantitative analysis. This is not only a reverie for recognition, but also a hope for better regulation and laws.


Fallback, cash flows and OIS discounting

In the IBOR fallback issue, there are different criteria we would like to impose in order to obtain a clean fallback. Among those criteria are the absence of value transfer and the coherence (IBOR is IBOR).

The fallback procedures proposed in ISDA consultation rely on the replacement of each IBOR fixing by an RFR-linked rate plus an adjustment spread.

The existence of CCP basis (and bilateral to CCP basis) which is potentially different between LIBOR products and OIS products leads to the following paradox: if we want to achieve the absence of value transfer, we need to select an adjustment spread that is different for the same IBOR and RFR depending on the clearing location, which is a violation of the coherence criterion. If we keep coherence, we have the same spread and consequently there is a value transfer.

Where is the paradox coming from? I would say that it is coming from a misunderstanding of the OIS discounting formula. The formula is written as (see Formula 8.6, based on Formula 8.3, Theorem 8.1 in my multi-curve book)

The formula looks like the valuation is obtained by discounting a cash flow. This is also what the popular name of the formula seems to imply; and this is also why I don't like the name. It gives the wrong intuition. The formula is correct but should not be interpreted as discounting a single cash flow. The reality is many cash flows (daily variation margin); the actual theoretical IBOR fixing is never paid as a single amount. The summary of all those daily cash flows into a single expectation is a very simple formula for a complex process. The formula is based on hypothesis, including perfect replication hypothesis by IBOR related instruments and OIS (hence the OIS discounting formula). But that replication is dynamic, with the hedging changing on a continuous basis, depending on the VM paid and the evolution of the market.

This approach is valid only where there is availability of the hedging instruments. In practice, it means that there is one formula coming from one pool of liquidity and one set of rules at each CCP (and at each bilateral agreement). Each CCP is its own world in term of hedging and price. Of course in practice it is possible to transfer risk (and thus price) from one CCP to another, but at a cost (the posting of IM, summarised in MVA figures). Between CCP prices there is not unique transformation of price but a price range, with the range depending of the IM rules and the cost of funding of potential arbitrageurs.

But this does not answer to the question: where is the paradox coming from. Based on the above analysis, my answer would be that there is no paradox in our criteria of asking for an absence of value transfer and a coherence on IBOR fixing. The problem/paradox/error comes from trying to solve the dynamic hedging problem with a static solution. The ISDA proposed solution (adjusted RFR + adjustment spread) is decided on the announcement date and is fixed from then on. Imposing a static solution to a dynamic problem leads to impossibility to obtain the price based on a dynamic world with segregated pools of liquidity.

The problem is not coming from our criteria, those are, to my opinion, fair requests, but from the constraints imposed on the solution which are not in line with the valuation framework where we want to apply them.


Answers to the ISDA consultation on IBOR fallback

The Japan Banker Association (JBA) has published its Comments on the Consultation on Interbank Offered Rate (IBOR) Fallbacks for 2006 ISDA Definitions.

Their comments are similar to the ones I mentioned in my Quant Perspective on the major issues:

Forward-looking term rates

we believe that ISDA should carefully consider how the development of forward-looking term rates will have impacts on the fallbacks for derivatives

This is in essence equivalent to my Option X1: OIS Benchmark but expressed in a different way.

The existence of the working group on GBP end EUR on the specific subject of the term rate RFR was already an indication that the decision of ISDA of not including the option in its consultation is not the first choice by all market participants. We have now also a similar opinion on the JPY side.

Not achievable option

There may be some cases (for example, in LIBOR in arrears swap) where it is unable to complete the fixing in time for floating rates payment.

This is essentially my point on dates indicating that the "street favorite" option of Compounding Setting in Arrears is not achievable, again expressed in a different way. If one is unable to complete the fixing, even for one single instrument, it means, based on equality or coherence between fixings, that the option is not achievable and cannot be proposed as a practical fallback.

This is the first time that I have seen an explicit opinion that support the issue I have highlighted since the first version of my quant perspective in April.

Second consultation?

The feedback reinforces my opinion that a second consultation would be necessary. Some important options have been ignored in the first version and practical achievability of one of the major options has still to be demonstrated.

Other answers

Other answer and articles related to the fallback are:

Article in Risk: Japan dealers unhappy with all Libor fallback options (subscription needed):

Answer by the European Financial Congress:


Speed of information is decreasing

Yes, I said decreasing. Nowadays nobody is interested by real time news. Receiving yesterday news today in the morning is what is required.

A least that is the impression I get when looking at the RFR new benchmarks and their publication dates.

Old New
Currency Name Lag Name Lag

Why publishing the result related to data collected immediately when one can sleep on it overnight? There is obviously the risk that insider information can be used in the mean time, but we would stay up at night for such a triviality?

Chacun sa méthode... Moi, je travaille en dormant et la solution de tous les problèmes, je la trouve en rêvant. (Personal translation: Each his own method... Myself, I work sleeping and the solution to all problems, I find it dreaming).

Drôle de drame (1937) - Marcel Carné

Probably some people at the central banks is needing a good sleep to dream yesterday benchmarks.

Why make it simple, when you can make it complex?

The T+1 issue is not just a transparency or "crazy quant that likes to rant about conventions" issue, this is a serious business problem, probably worth millions if not billions of dollars in developments. One of my previous blogs, on Variation margin in presence of trade cash flows, was one example of where the difference between T+1 and T can be huge in the flow of information for derivatives. All the collateral management would be simplified without the delay. When regulators are pushing for overnight based derivatives, the least we can expect from them is to smooth the path to adoption. The difference that T+1 makes is probably the impossibility to settle the overnight-linked derivatives on their natural settlement date. For currencies trading internationally, from Japan to US (in day light chronological order), those 14 hours difference between 7:00 p.m. and 9:00 a.m. is the difference between settlement processes that are achievable and those that are not achievable.


IBOR Fallback: Compounded Setting in Arrears

I continue my quest related to the IBOR fallback issue. I still fail to understand the precise meaning of the "Compounded Setting in Arrears" option for derivatives subject to the fallback.

I have contacted several people at ISDA (as reported here) and others that are mentioning this option. I have not yet received a clear answer to the issues I have reported in my "Quant perspective on IBOR fallback" and in my answer to the ISDA consultation. The dates between the IBOR underlying deposit and the derivatives do not match in all cases. How do you pay an amount before you know how much you have to pay (the time difference can be as long as the IBOR tenor)?

The answers I received are some version of "To be decided", "The impacted trades will mature before the discontinuation", or "The term sheets will change in the mean time". All of those answer do not answer the content of the question:
  • To be decided: No! The details have to be described before the consultation, before the user sign a contract, not after.
  • The impacted trades will mature before the discontinuation: No! FRA traded today may mature before 2022, but between now and the discontinuation many new FRA will be traded. The ones that will be traded the day before the discontinuation need to be taken into account in today's fallback definitions. Moreover the impact is also on vanilla swaps. Some have a maturity of more than 50 years; discontinuation will take place before 2068!
  • The term sheets will change in the mean time: Maybe! But if you thing so, show me the proposal for ISDA definition that include those changes. They should be included before the fallback amendments, not after.

To repeat myself:
The term rate fallback problem is a term rate problem, not an overnight problem; even if the fallback is overnight-linked, a term rate is required for the solution.
I prefer a clean fallback based on imperfect term benchmark than a dirty fallback based on a perfectly compliant overnight benchmark.


Mentioning November 11th!

Risk published an article on the different initiatives related to the term RFR rates: Search for term Libor replacement hits twin barriers (subscription required).

I was interviewed by Risk a month ago on the subject of the term RFR rates and the IBA "ICE term RFR" based on SONIA. I also posted a blog on the subject a month ago: ICE Term Risk Free Rates.

Risk magazine quoted me saying (yes this is me quoting someone quoting me):
“The futures have a fixed start date and end date; say from 1st of month to 1st of next month. What we need for term benchmarks is from today to today plus one month or three months, for example, from November 11 to December 11. How do we extract that information from the futures? We have to get part of the information from the November 1 to December 1 futures and part from December 1 to January 1. How this is done is subjective and depends on information that is not visible in the futures market,” says Marc Henrard, head of quantitative research at vendor OpenGamma in London.

The true quote should have been
"The futures have fixed start date and end date (say from 1st of month to 1st of next month). What we need for term benchmark is from today (or more exactly t+2) to today +1M or 3M. Today 9th October, we want the rate between 11th October and 11th November (adjusted). How do we extract that information from the futures? We have to get part of the information form the 1-Oct to 1-Nov futures and part from 1-Nov to 1-Dec. How this is done is very subjective and depend of plenty of information that is not visible in the futures market."

The difference between the two are the dates. The interview took place a month ago (on 9th October) and they updated the starting month from October to November to match the publication date, but did not adapt the day of the month accordingly. To prevent any sarcastic comment, I need to clarify that I know that Sunday 11 November is not a good business day; no LIBOR deposit has its effective date on that day. Also the discussion was generic about USD, GBP and EUR. I know that the GBP LIBOR standard is T+0 and not T+2.


Visiting Professor UCL

I'm proud to announce that my appointment as Visiting Professor in the University College LondonDepartment of Mathematics has been extended to May 2021.


SOFR: multiple basis

A couple of weeks ago, CME announced that they cleared their first SOFR-linked swaps.

The first trades where cleared by BNP Paribas, Credit Suisse, J.P. Morgan, Morgan Stanley and NatWest Markets. The total notional was USD 200 million without details on the type of swaps or their maturity.

The main difference between the SOFR-linked swaps cleared at LCH and those cleared at CME is the Price Alignment Interest (PAI)/collateral rate. For LCH it is EFFR while for CME it is the SOFR itself. Both CCPs accept OIS (Fixed v SOFR) and basis (LIBOR v SOFR and EFFR v SOFR). Also LIBOR, EFFR and SOFR futures are traded.

This means that now we have the full spectrum of legs types, PAI and adjustments:
  1. LIBOR leg with EFFR collateral (LCH, CME, bilateral)
  2. OIS-EFFR leg with EFFR collateral (LCH, CME, bilateral)
  3. OIS-SOFR leg with EFFR collateral (LCH, bilateral?)
  4. LIBOR leg with SOFR collateral (CME in basis swaps)
  5. OIS-EFFR leg with SOFR collateral (CME in basis swaps)
  6. OIS-SOFR leg with SOFR collateral (CME)
  7. Futures-LIBOR with 0 collateral (CME)
  8. Futures-EFFR with 0 collateral (CME)
  9. Futures-SOFR with 0 collateral (CME, ICE)
Hopefully, we will be soon able to add the Risk-based OIS futures, which present a mixture of zero collateral in their futures phase and overnight collateral in their cleared OTC phase.

In theory that would be enough information to calibrate convexity adjustment models for change from one collateral to another. In practice, there is not enough liquidity yet to obtain meaningful results. We are entering an interesting era where the answer to the question:

is more and more:

ISDA consultation on LIBOR fallback - my answer

The ISDA Consultation on Certain Aspects of Fallbacks for Derivatives Referencing GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW closed yesterday.

I have send my answer to the consultation last week. The document of my answer can be found below.


ISDA fallback consultation extended

The deadline for the responses to the ISDA Consultation on Certain Aspects of Fallbacks for Derivatives Referencing GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW has been extended. The date has been changed from Friday 12 October to Monday 22 October 2018.

You still have the week-end to read the documents and answer to the consultation.


ICE Term Risk Free Rates

I will start with my usual rant about "risk free". SONIA is based on unsecured transaction and is credit risky. Not risk free on the credit side. A term rate is, as its name says, fixed for a term and the value of a term instrument changes when the market changes during that term. Not risk free on the market side. I cannot understand why this incorrect terminology of "risk free" is so widely used while plenty of correct and more meaningful terminology are available: collateralised rate, overnight-linked rate, overnight-indexed rate, derivative term rate, alternative rate (I don't like alternative rate too much either, it opposes the current name to a previous approach instead of positively describing the present, but it is better than risk free),

IBA (ICE (InterContinental Exchange) Benchmark Administration; I like those acronyms based on acronyms) is launching a "ICE term RFR". The term rate is based on futures prices. The first version is SONIA-linked.

As a reference term rate, I would prefer, as I mentioned in my "Quant Perspective on IBOR Fallback Proposal", a benchmark based directly on OIS than one constructed, through a curve model, with futures. Contrarily to what is indicated in the ICE paper on term risk free rates, the transaction data do not need a "financial model to generate yield curves" if OIS rates of the correct tenor are directly used. The model is required mainly in the futures case.

Regarding OIS, the ICE paper indicates the prevalence of forward starting and MPC meeting OIS. It would be good to have clear statistics on how much is traded on 1, 3, 6-month tenors and other dates.

The futures daily volume is around 4bn. This is below the 40 to 50bn of ON depo that are used for SONIA itself. This is a decent number. The paper claim that the "data is available", but is it "freely available to all market participants and researchers"?  I don't thing so (at least I have not found the data yet). My request for benchmarks has been for a long time total transparency. To be totally useful and informative, the "ICE term portal" should provide the detailed futures data on which the term rate is based (and if possible without several layers of legal agreements).

Even if I started with not extremely positive remarks, to my opinion this is a good proposal. This is a benchmark that would be available in London morning (at least its intraday version). GBP LIBOR fallback would be improved if the fallback (term) rates are available shortly after 11:00 am London time, like LIBOR itself. In the waiting for a more robust OIS benchmark, this would be a good starting point. It could be used as the first waterfall step of a multi-stage fallback as proposed in the Section 6.11 of my perspective.

IBA analysis of the usefulness of a "term RFR" is similar to some extend to the one I have developed in my "quant perspective" (Section 3.5), except that they do not mention the LIBOR fallback issue in their note. To my opinion the fallback is where their proposed futures-based term rate could be useful as it would be immediately available. I think it cannot replace an actual OIS based benchmark for term rates on which the most liquid derivatives would be based as the subjective model part could have a large impact.

For the methodology itself, it is based on a quite standard curve calibration with overnight forward rate following a step function between MPC meetings. Such a mechanism is for example described in my multi-curve book in Section 5.11. On top of this there is an arbitrary 1st of month jump in months without MPC meetings. Any other day of the month would be as good in theory. In practice, a mid month would probably be better to avoid too short constant rate periods. When a MPC meeting is on 22th March, there are only 9 days to month-end. Even better than mid-month, it could be slightly earlier to be on average in between the two MPC meetings or month specific to be equal distance of the two surrounding meetings once the actual dates are known. The curve calibration process used for the benchmark is a simplified version of what one would like to use for market making on short term OIS as it does not take into account the intra-month seasonality.

For example in GBP SONIA, the year end and quarter end have usually rate fixing lower that surrounding dates. The year end has seen jumps up to 12 bps in the last years. With year-end being 4 days on 4 years out of 7, this is nor a negligible figure. If we look at SOFR data, there is a clear intra-month seasonality — end-of-month and around 15th of the month have higher rates. A simple flat overnight rate interpolation between FOMC meetings is not good enough. This subjective data will have an important impact.

Wait and see if there is any interest for it from regulators or from ISDA for the IBOR definition fallback.


A Quant Perspective on IBOR Fallback Proposals - Version 1.1

I have received numerous feedbacks on my "Quant Perspective on IBOR Fallback Proposals" document. I have updated the document and a version 1.1 is now available on SSRN: https://ssrn.com/abstract=3226183

Don't hesitate to contact me for discussion about the subject.

Convexity adjustment for Option 1: Spot Overnight Rate. See the note for the details.


Six months of Fed Funds market expectation in ten seconds.

The US Fed has hiked rates several times in the last year. What was the market's expectation for those hikes six or twelve month before they happened? To estimate that, you can ask many market participants about their expectations every day and then average the answers. This is the polling approach.

Instead of asking where their mouth is, you can also look where their money is. Interest rate derivatives are the most liquid financial instruments, worth a lot more than many mouths. How do you read the market expectation in derivatives? The overnight-indexed swaps (OIS) are linked to the Effective Federal Fund Rates (EFFR). Those swaps are liquid and usually trade with standard tenors like 1, 2, 3-months. It is possible to extract from those instruments the market expectation about futures rates. This can be done in a systematic way using curve calibration on those OIS with interpolation mechanism that imply constant rates between FOMC meetings and allows for jumps on those dates.

I have done the curve calibration on a daily basis on a 6-month period. Each day the curve is calibrated to market OISs, taking into account the FOMC dates in the next year. The forward rates for each day over the year after the calibration is computed and displayed in a graph.

Putting together those graphs produces a 10 seconds movie representing the market expectation over a 6-month period (from June 2017 to January 2018) of the next 12-month on calibration date.

In the graphs, the actual EFFR fixing as published by the Fed are represented in red. They represent the realized rates with full insight. For each date, the expectation for each day in the next 12-month is represented in blue. We insist that the two colors represent very different things, the red is backward looking after the date (realized path), the blue is forward looking for the next 12 months and updated each day.

With this representation you can see the market expectation changing (slightly) each day and in most cases converging to the FOMC decisions.

The movie can be found on YouTube at https://youtu.be/pqv3sIVjz7c

Don't hesitate to contact me for production implementation of those curve calibration methods. The technical description of the method can be found in Section 5.11 of my Interest Rate Modelling in the Multi-curve Framework book.

Note: The movie was produced with is a simplified curve description template. It does not include month-end expected behavior. Exogenous intra-month seasonality can be added to the curve to obtain an even more realistic forward behavior (Section 5.9.4 in the book). 


Risk-based overnight-linked futures

Some years ago I proposed an innovative design for risk-based swap futures.

I worked with ASX to adapt it to the AUD BBSW swap market and a product based on that design has been traded on the exchange since 2016 (even if it has not attracted a lot of trading activity).

With the new importance of overnight benchmarks, the ETD market has to find a product that could be used for price discovery and risk management of the full term structure of interest rate.

I have detailed a version of the generic futures design to match the overnight conventions and OTC markets. The product has been presented to the main interest rate futures exchanges in Europe and the USA. We will see if it takes a new life.

The technical details are now available in the form of a note. The document can be downloaded from SSRN at https://ssrn.com/abstract=3238640.

In the graph below I have displayed the convexity adjustments between the ETD futures and the OTC swaps that can be obtained with this design (in red) and the ones with the current design of overnight-linked futures. See the paper for the exact description of the graph.

Consultation on IBOR fallbacks: Question 3

Game of Benchmarks: Season 2

Game of Benchmarks: Season 2 - Episode 3: Timing


Question related to: Description of Adjusted RFR - Fixing timing

The simplest option for adjusted RFR in the ISDA IBOR fallback consultation is Option 1: Spot Overnight Rate. The option simply replaces an IBOR fixing on a given date by an Overnight fixing on the same date.

Even this simplest option has to be assessed carefully in term of practical achievability. The overnight rate are known only at the end of the fixing date or the next day in the morning while the IBOR fixing are known shortly after 11:00 am. Is there some provisions in some derivative contracts that would require to know the fixing by 11:00 am? For example the cap/floor are exercised — even if it is automatic exercise — at 11:00 am. Can the exercise mechanism be delayed to the end of the day or even the next day? The fallback provision should describe what would happen to the contracts that have a tied schedule linked to the fixing time. The GBP FRA may be one of those types of contracts where knowing the fixing result at 11:00 am is important as they have to be paid on the same day. What would happen to the fallback provision if the derivative contract is written in such a way that obtaining the fixing by 11:00 am or shortly thereafter is important?

A list of FAQ is maintained by ISDA.

Season 2: The questions


Question 1: Question related to Option 3: Compounded Setting in Arrears Rate

Question 2: Question related to: Description of Fallbacks - Triggers

Question 3Description of Adjusted RFR - Timing


Short note on long-term repos

The market infrastructure for interbank lending and derivatives has dramatically changed over the last ten years. The interbank lending is done now mainly on a secured basis. Derivatives are margined daily with variation margin guaranteeing the full present value of the trades. The world of interest rate benchmarks is also rapidly changing with the possible discontinuation of the IBOR benchmarks that have reigned on the benchmark kingdom over the last 30 years and the emergence of secured rate overnight benchmarks.

All derivative users are now well aware of the difference between overnight-indexed swap (OIS) rates and term LIBOR deposit rates even if its discovery may have been sudden to some market participants in 2007.

When we combined the secured term lending, the collateralised derivatives and the secured benchmark, what is left of the OIS-term deposit difference? This is the question I try to answer in a brief note now available on SSRN at https://ssrn.com/abstract=3258690

Using simple no-arbitrage strategy with daily hedging I prove that the collateralised OIS fix rate when the underlying benchmark is an overnight repo is equal to the term repo rate on the same period.


Term RFRs

At a recent ISDA meeting, a FCA representative, Edwin Schooling-Latter, positively commented on the achievability of term versions of RFRs. His comments are presented in a recent Risk article titled ''Term versions of RFRs will work – FCA official''.

This comments goes in the direction of the opinion of many (but not all) market participants but is in opposition to many regulators public comments (in particular the FSB OSSG) and against the indication in the FAQ associated to the ISDA consultation on IBOR fallback. The term rates are not even an option in the ISDA consultation.

There are two different issues associated to the "term rates" question: the IBORs fallback and the standard for new trades.

For new trades, you can change the rules and do what you want/is the most convenient in the circumstances.

For legacy trades, the fallback changes the reference rate when the contractual one is not available, but does not change the other aspects of the contracts. For those, a term rate is a requirement, not merely one of the options. The choice is between a term rate and chaos (with different levels of chaos possible). It seems there is a willingness to move the main benchmarks from Interbank (IBOR) to pseudo-risk-free rate (RFRs). If this is the case also for IBOR fallback, the choice is between term versions of RFRs and chaos.

My interpretation of the backing by FCA of term RFR is the following: "better to have a meaningful number which make sense than to have market chaos".

My equivalent interpretation of refusal of term RFR by other regulators is: "better to have chaos than to change the wording of a previous opinions based on a political agenda for the market".

There was manipulation of benchmarks in the past, and it is better to avoid it as far as possible in the future. Should it be at the cost of destroying the present or should the future be constructed in a orderly and efficient way taking into account the present?

All of the above are personal interpretations, opinions and questions!


EUR Overnight Benchmark - ESTER

The ECB has announced the result of the public consultation about the alternative EUR overnight benchmark. As expected, the ESTER rate, to be published by the same ECB, has been recommended by the Working Group on 13 September 2018 be used as the risk-free rate for the euro area.

I still don't like the name risk-free rate (RFR). As described on the ECB ESTER page, "ESTER will reflect the wholesale euro unsecured overnight borrowing costs of euro area banks". The rate is for unsecured and credit-risky transactions.

The world is now divided in two groups, one where the reference overnight benchmarks are secured overnight rates - e.g. USD and CHF - and one where the reference overnight benchmarks are unsecured overnight rates - e.g. EUR and GBP. That can only increase the cross-currency basis and give more work to quants.

On the secured rate front, we will soon have two competing term rates: OIS-like derivatives based on repo overnight rates and term repos. What is the link between them? In the unsecured world, there was a clear difference between the OIS rate based on unsecured overnight rates and term unsecured deposits (IBORs). What happen to this clear difference in the secured world, where repos are collateralised (usually by bonds) and derivatives are collateralised (usually by cash paying repo-based benchmark rates)? Note on that to follow shortly.


More overnight products

Another overnight-linked futures. CME is planning to launch SONIA futures. The futures would come in two flavours: Quarterly IMM dates and MPC meeting dates. More details can be found on CME website at https://www.cmegroup.com/trading/interest-rates/sonia-futures.html. To my knowledge, this is the first time that a central bank meeting date futures is launched. The central bank meeting date futures is one of the options I had proposed in my design of overnight-linked futures.

Other financial institutions issuing SOFR linked paper.

Credit Suisse has issued a six-month certificate of deposit linked to SOFR. The paper pays SOFR+35bps. More details in the FT article "Credit Suisse becomes first bank to issue debt tied to Sofr"(subscription required).

Barclays has issued commercial paper linked to SOFR. See the Bloomberg article "Libor Challenger Embraced in Debut Commercial Paper Transaction".


A Quant Perspective on IBOR Fallback Proposals

A month ago, ISDA launched a consultation on IBOR fallbacks. The question of the fallback in case of a benchmark discontinuation has obviously legal background. Parties to the derivatives contracts have to ask themselves: What is the meaning of what I signed? Is it really what I want? The answer to the last question is probably: "no, it is not what I want!" This is why most of the derivatives users agree that a change in the fallback language is required.

Once you are convinced that what you have is not what you want, you have to review the alternatives. I have published a note with a personal review of the alternatives from a "quant" perspective. Even if personally I would prefer to the called it a "qualitative analysis" as before assessing the quantities associated to the alternatives, you have to check their qualities against a set of qualitative criteria.

The note gives some background for the Season 2 of Game of Benchmarks: The Questions!

The note is available on SSRN:

A Quant Perspective on IBOR Fallback Proposals


With the increased expectation of some IBORs discontinuation and the increasing regulatory requirements related to benchmarks, a more robust fallback provision for benchmark-linked derivatives is becoming paramount for the interest rate market. Several options for such a fallback have been proposed. This note describes and analyses some of those options. The focus is on the quantitative finance impacts. None of the options that have been proposed fits all of the criteria for a good fallback provision. It appears that some of the options that have gained traction failed even the achievability criterion. The note concludes with the author's personal preference.

Season 2: The questions


Question 1: Question related to Option 3: Compounded Setting in Arrears Rate

Question 2: Question related to: Description of Fallbacks - Triggers

More SOFR products (II)

More and more SOFR-linked products appear. This time it is the World Bank which issued a SOFR-linked floating rate note (ISIN: US459058GK33), with a two-year maturity and a coupon of SOFR+22bps paid quarterly with a 4 days lockout. The notional issued was 1 billion notional. This is the longest maturity I have seen so far for a SOFR-linked instrument. Once more a lockout period which transforms a compounded setting in arrears into a partially setting in advance rate. The press release can be found here.

It appears that on the same date very large SOFR v LIBOR swaps were traded. The total notional of the swaps was USD 920 millions. More details are provided in the Risk article World Bank completes first SOFR bond hedge.

muRisQ Advisory

Over the past couple of years, in parallel to my work as Head of Quantitative Research at OpenGamma,  I have been working as a freelance advisor on a couple of projects. Those projects include designing of a new interest rate futures, presenting multiple executive training, advising hedge funds on the multi-curve and collateral framework, advising on CSA, Variation and Initial Margin frameworks and commenting on regulations.

For those projects, I'm working under the structure of an independent advisory firm called muRisQ Advisory. Its (concise) website can be found at http://murisq.com/

Don't hesitate to contact me regarding its services or for training, model validation, product design and risk management strategies.


Benchmark and CSA

The following quotes are from a recent article in Risk titled "Esma: Eonia can be used in CSAs after 2020".

Jakobus Feldkamp, senior policy officer for market integrity at the Paris-based European Securities and Markets Authority, tells Risk.net that CSAs will not be dragged into the BMR.

“Esma agrees that it can be argued that a reference to Eonia in a bilateral agreement on an individual exchange of collateral under an OTC derivative is not strictly ‘use of a benchmark’ in the sense of the BMR,” says Feldkamp.

The Article 3 (1) (7) of the European Benchmarks Regulation (BMR), refers to
"determination of the amount payable under a financial instrument or a financial contract by referencing an index or a combination of indices".  The regulation enters in full force on 1 January 2020. The question behind the interpretation of this sentence is to know if CSA referring to EONIA can still be legally used in Europe after that date. Not a minor issue certainly.

The quote from Feldkamp says "Esma agrees that it can be argued [...]". It does not say that it is ESMA's position that CSAs are not financial instruments, only that ESMA agrees that someone else can make that argument, a very different meaning.

But I'm not a lawyer, so what do I know about the meaning of a sentence?

I'm not a lawyer, but I'm a financial engineer (or at least I can claim that I'm one as the title is not protected, see the list of regulated professions in Europe). What about the following situation. I draw a derivative contract with a counterparty. The contract is a fixed v fixed swap that pays net 1 (thousand, million, billion, chose the amount according to your wealth) EUR in one-year time. The contract is under CSA with EONIA collateral. What is paid under such a contract? EONIA collateral rate, compounded over one year. Miracle, this is exactly the payoff, up to the notional payment, of the floating leg of an OIS. This is pure coincidence, I swear it! To make the things clean, I have to remove the collateral initial and final payments, but that can be easily done with a fixed amount payments. I write the fixed amounts contract as a loan and not a derivative, so it does not need collateral. (I can provide an exact term sheet if you hire me as a consultant ;) )  We put in place a netting agreement between the derivatives and the loans to avoid economic credit risk. This does not affect the collateral as the margin regulation explicitly prohibit to take those cross-products netting agreement into consideration for the computation of the collateral on derivatives. I have just created a legal synthetic OIS in EUR using derivatives, CSA and loans when a simple OIS would be illegal!

What is the goal of the regulation? Make the risk management of financial risk for people that need to manage it more difficult and requiring financial engineering or to make the market safer and more efficient? I see more of the former here, but maybe my eyesight is getting poor.

It is very good that the press asked this important question and was able to get an answer. That what the press should do and I congratulate the journalist for that. But personally, I would have preferred that such an announcement, which amounts to a regulatory decision, was done publicly, for example on the ESMA website and not in a private for-profit news magazine. If I was not a subscriber of the magazine, I would not know about this new ESMA policy.

The list of benchmark administrators registered under the new regulation can be found on the ESMA website at https://www.esma.europa.eu/benchmarks-register


More SOFR products

A floating rate note and a futures, this is what this week brings us on the SOFR front.

Fannie Mae has launched SOFR-indexed notes. The issuance is described in a Risk article: Investors cheer debut Fannie SOFR note launch. Three notes with maturities of 6, 12 and 18 months are issues, with spread of 8, 12 and 16 basis points above compounded SOFR. The accrual periods ends with a four-day lock-out period, similar in some way to the two-day lock-out for the Fed Fund swaps. Once more this means that the debate between forward-looking term rates and compounding backward looking rates is wide open.

In the same week, the Intercontinental Exchange has announced October 1 Launch of ICE One and Three Month SOFR Futures. This extends the ICE overnight offering beyond the SONIA futures for which 100 billions notional have been traded and competes with the similar products at CME.


Consultation on IBOR fallbacks: Question 2

Game of Benchmarks: Season 2

Game of Benchmarks: Season 2 - Episode 2: Triggers


Question related to: Description of Fallbacks - Triggers

In the triggers description, the benchmark to which a fallback would be applied is called “the relevant IBOR”. The list of those relevant IBOR is “GBP LIBOR”, “CHF LIBOR”, “JPY LIBOR”, etc. The relevant IBOR does therefore not include the tenor.

It is not clear from the text if the trigger applies on a tenor by tenor basis or on a full “family". Could there be a situation where one tenor, e.g. GBP-LIBOR-12M, is discontinued but not the others in the same family, e.g. GBP-LIBOR-3M. Would the discontinuation of one tenor trigger the fallback for all of them?

Could you clarify the tenor/family issue in the FAQ and potentially adapt the trigger wording?

Edit on 18-Aug-2018:

I have received an answer from ISDA regarding the above question:

If the discontinuation is of one tenor only, then it is likely that market participants will follow the interpolation approach that they followed when certain LIBOR tenors were discontinued several years ago.  The fallbacks we are implementing contemplate discontinuation of all tenors (although this is not yet a hard and fast rule because we are still confirming that there are no scenarios in which our fallbacks should apply to a tenor discontinuation - but I think that would be unlikely).

A list of FAQ is maintained by ISDA.

Season 2: The questions


Question 1: Question related to Option 3: Compounded Setting in Arrears Rate

Question 2: Question related to: Description of Fallbacks - Triggers

Question 3Description of Adjusted RFR - Timing


Consultation on IBOR fallbacks: Question 1

On 12 July 2018, ISDA has published a Consultation on Certain Aspects of Fallbacks for Derivatives Referencing GBP LIBOR,1 CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW.

I'm preparing a quant perspective on IBOR fallback proposals that I will publish in the coming days.

In the mean time, by reading the consultation document, I have a certain number of questions related to the clarification of the wording or the formulas proposed. I'm sending the questions to the ISDA email associated to the consultation and I'm also posting them here. I will update the post when I have an answer or a clarification. This is

Game of Benchmarks: Season 2

Game of Benchmarks: Season 2 - Episode 1: Compounded Setting in Arrears Rate question


Question related to Option 3: Compounded Setting in Arrears Rate


The three dates that characterise a IBOR fixing are its fixing date, the effective date of the underlying deposit and the maturity date of the same deposit. When used in derivatives, the effective and maturity dates of the underlying deposit are theoretical dates as no actual deposit takes place. Derivatives payments are themselves characterised by four dates: the fixing date, the start accrual date, the end accrual date and the payment date.

The consultation document indicates "The fallback could be to the relevant RFR observed over the relevant IBOR tenor and compounded daily during that period.” A formula is provided in Annexe A.

It is not clear if the “period” referred in the text (T to T+f in the annexe) is the IBOR theoretical deposit period or the derivative period.

If the period refers to the IBOR theoretical deposit period: How would the RFR for the period been know if the payment takes place before the end of the said deposit period. This would be the case for FRA with “FRA discounting” settlement (settlement in advance), for IBOR with fixing in-arrear or for vanilla floating coupons on coupons after a period with end accrual date on a non-good business day.

If the period refers to the derivative period: Does that mean that the same IBOR fixing will fallback on different values depending in which derivative it is referred and the consistency between rates fixing on the same date will be broken? What would be the period for a FRA that settles on the fixing date (e.g. GBP-LIBOR)?

Edit on 6-Oct-2018:

I have received an answer from ISDA regarding the above question:
This is an issue that we are going to need to look into for each of the relevant currencies as we move to implementation (if we move to implement the compounded in arrears rate).  The likely answer is the IBOR theoretical period with an adjustment for the payment date but it would be helpful if you could point out this issue in your response and explain the implications.

Season 2: The questions


Question 1: Question related to Option 3: Compounded Setting in Arrears Rate

Question 2: Question related to: Description of Fallbacks - Triggers

Question 3Description of Adjusted RFR - Timing


First cleared SOFR trades

Last week, on Wednesday 18 July, LCH has announced the first cleared SOFR linked swaps.

According to a Risk article (subscription required), the first trade was a SOFR V EFFR basis swap.

Now the real fun start. Compute all the basis and check how they behave!


Risk-based futures

Financial Fiction Episode 3: Risk-based futures

For linear interest rate derivatives, risk and DV01 are considered as very similar expressions.

This is also what we can deduce from the name of the latest new futures launch by NASDAQ.

Some five years ago, I proposed a new design for interest rate futures that I called risk-based futures. I worked with ASX in 2014 to adapt the design for the AUD market. At the end of 2015, ASX launched a swap futures based on that design. The ASX product has an extra feature of having a variable tick value, but the central feature of the design is the same: a futures price representing a rate or yield and the physical delivery of an ATM trade on the futures expiry.

NASDAQ will be launching soon its DV01 Treasury Futures. According to NASDAQ, the new product will be available for trading on Thursday, July 19, 2018, pending regulatory approval.

The name "risk-based futures"(1) has been changed to "DV01 futures", but the central idea is the same: future style margin on the price multiplied by a conventional DV01/PVBP and physical settlement at expiry into an at-the-money trade.

In my generic design the delivery mechanism can take several variants. NASDAQ has selected the simplest one where the notional of the delivered trade is fixed in advance. This create a jump in risk at delivery. The risk jumps from the futures term-sheet DV01 (e.g. 850 USD by basis point for the U.S.10-yr DV01 Treasury futures) to the actual DV01 of the delivered instrument. The variant is to deliver at expiry a trade with a notional adapted to smooth the risk.

The design of the futures I proposed is very versatile. As mentioned above, ASX has proposed a version; the underlying is a BBSW swap. The NASDAQ is now proposing a version with US Treasury underlying. I have proposed a version for the overnight-indexed market. The overnight-linked market is expected to become more important with the increased importance of SOFR, SONIA and probably a new EUR overnight benchmark. I will publish the details of the OIS based version in the coming weeks.

Another financial fiction becoming reality! See Financial Fiction 1 and Financial Fiction 2.

(1) I used that name at the The 3rd Interest Rate Conference (London, UK) in March 2015 in a presentation with the title Deliverable Swap Futures: a risk-based design.


Triple basis

In a recent Risk article (Clearers diverge on SOFR swaps discounting - subscription required) it was indicated that, contrarily to previous announcements, when CME will start to clear SOFR linked swaps, the interest used for Price Alignment Interest (PAI) will be SOFR itself and not the EFFR which is used for other USD OTC derivatives. This is also a departure from the initial ARRC suggestion. Regarding LCH, the current indication is that it will clear SOFR linked swaps with EFFR PAI.

This means that out of the six variations of overnight-linked derivatives discussed in a previous blog, five will be available in Q3. It is not certain that the sith variations will ever be really traded, but we can expect that if SOFR is becoming the benchmark benchmark (I'm not sure it is the correct term, but it seems appropriate here) at some stage some legacy EFFR OIS will switch to SOFR for collateral.

From a long term perspective, it seems logical to clear SOFR based swaps using SOFR collateral interest. Starting with EFFR collateral would mean that at some stage in the future, the CCP rule or the master agreement would need to be changed to switch to the new rate.

Now a trick questions: When will the basis swaps EFFR v SOFR start to trade/clear? What will be the PAI on those swaps?

Over the recent years we have seen the appearance of a basis between swaps traded at different CCPs. With this announcement we will see the appearance of a triple basis: on top of the CCP basis, we will have the discounting basis (SOFR v EFFR) and the "convexity adjustment" basis (on SOFR forwards). It will be impossible to untangle those basis as there will be for the moment only a limited number of traded swap types out of the multiple combinations and no option market yet.


EIB SONIA-linked bond

The move to the use of overnight benchmarks as the main interest rate benchmarks is progressing. After the wave of new overnight-linked futures in the last months by CME, ICE and CurveGlobal, we now have a large overnight-linked bond issuance. The EIB has successfully issued a one billion 5-year SONIA-linked bond.

The coupon payment is based on the backward-looking overnight SONIA composition plus a spread of 35 basis points (Maturity 2023-06-29, quarterly payments, ISIN XS1848770407). Note that a small 2 millions bond had been issued in January (quarterly SONIA + 25 bps, maturity 2023-03-20, ISIN XS1889459713). Thanks to an acute observer of the market for pointing that to me.

Backward-looking overnight is viable. Certainly for some issuers and investors. There was never a doubt about it for some market participants. This does not prove it is viable for all market participants, and this is where the question lies. Note that the coupon will be paid with a five-day lag after the last overnight benchmark fixing. This is a serious discrepancy with the current overnight-linked derivative market which pays with a zero day lag in Sterling (and 2 in EUR and USD). Some elements of the issuance are discussed in a Risk article 'EIB shrugs off term RFR worries with Sonia bond plan' (subscription required) and a Financial Times article 'EIB to offer Libor alternative with Sonia-based bond' (subscription required).

The question of backward-looking or forward-looking — i.e. OIS benchmark — overnight-linked coupons is heavily discussed in the potential LIBOR discontinuation and fallback provisions. The EIB issuance, even if linked to backward-looking overnight benchmark, does not bring any substantial positive information regarding the fallback discussion. If anything, the five-day lag expresses the difficulty of that approach. The backward looking payments have been used for many years in the derivatives market and there is not doubt that they are working for products designed with its requirements in mind.

Regarding the LIBOR fallback, the products linked to LIBOR have been designed with the term rate at their core. Can we replace a term rate by a backward-looking rate? That is the question. The answer is: in some case yes and in some cases no. The obvious 'no' are FRA with FRA discounting settlement and LIBOR in-arrear that require a payment at the start of the term period. As the fallback procedure should be the same for all LIBOR usages in derivatives, the global answer to the fallback procedure question has to be 'no, a backward-looking fallback is not possible'. The above answer is not only a personal opinion, it is a physical impossibility, except if one can realize backward time travel.

I will provide more technical details and opinions about the LIBOR fallback in a forthcoming notes. Hopefully I will have time to finish it by mid-July.