2018-11-30

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.

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