2018-11-29

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.

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