Short story on the fallback protocol cost.

Another episode in the finance fiction series!

Everything below is pure fiction.

I'm an end-user with a LIBOR swap transacted with my trusted bank on a bilateral uncleared basis. I receive LIBOR (and pay fix) for 10 years. I don't sign the ISDA proposed fallback protocol and my swap stay under current ISDA definitions.

Move forward to the future:

Come the first reset date after the discontinuation date. The LIBOR rate is not published on Reuters screen LIBOR01. We call four reference banks in London at 11:00 am London time, none of them provide a quotation of its rate. We call four reference banks in New York at 11:00 am New York City time, none of them provide a quotation of its rate. The fallback in the ISDA definition stops there (See ISDA definitions, Article 7, Section 7.1. Rate Options. (ab) U.S. Dollar. Paragraphs (xxii) and (xxv)).

We can not agree on a rate on a bilateral basis with the bank counterparty. We go to court/arbitrage to get an independent assessment of what we should do. The judges/arbitrators look at the case. In the swap contract, the parties expressed the desire to make a payment linked to LIBOR, a measure of the interbank unsecured borrowing cost, including term credit risk. The judges/arbitrators, being financially literate look at the possible options. The ISDA fallback method based on SOFR and a fixed spread does not contain any bank term lending or credit risk, hence it is not an option than independent financially literate judges/arbitrators can even consider. The only feasible option they find is to use the USD Bank Yield Index.

This is not a recognized benchmark, but at the time when both LIBOR and USD Bank Yield Index were published they were very close. Linking the payment to the USD Bank Yield Index seems fair and reasonable. The Index is not officially recognized, does not satisfy EU Benchmark regulation and cannot be used explicitly in contracts, but the judges/arbitrators are not under the regulation and are allowed to award a payment linked to it.

Move back to today:

Because this decision by a court/arbitrage seems to me the most likely solution, I price today my LIBOR swap using that specific pay-off: USD Bank Yield Index. There is no liquidity for those pay-off, they are even forbidden by regulation to appear explicitly in contracts, but I can value them for my own information using this pay-off. I can not value them using standard replication arguments, there is nothing to hedge to risk. For my personal appraisal, I can value it using some kind of best econometric judgement.

My best judgement is that there will be soon another bank credit crisis. My expectation is that the spreads will move up after 2022 and be a lot larger than today. Can I justify this assumption? Yes! One year ago, before the consultation of LIBOR fallback, the long term LIBOR-OIS spread were around 40 bps. Before LIBOR was polluted by the fallback, the general view of the market was also that some type of credit spread crisis was likely.

We want to cancel the swap with our bank counterparty. I value the LIBOR leg at OIS + 40 bps; the bank value it with the broker quotes for interbank cleared swap at LIBOR at OIS + 20 bps. This is a difference of 20 bps over 10 years, I'm expecting to receive as a settlement amount roughly 2% of notional higher than what my counterparty is willing to pay; we can not reach an agreement.

My counterpaty suggest that we sign the ISDA protocol. My answer is: Not a problem at all! Simply pay me 2% of notional and I sign! They are surprised by my request of payment to sign the protocol. I'm surprised by their surprise! Are the incompetent or have they been trying to deceive me? I vaguely remember a similar story from the past about signing a new CSA agreement and some collateral delivery option; I don't remember the details, but for sure I remember that the impact was not neutral and not in our favor.

Morality of the story:

Before signing the fallback protocol, make sure you understand the cost involved. The clear market quoted swap on broker screen does no represent the true value of your uncleared swaps; you may find a fair difference of 20 bps between the two. Take expert independent opinion on it.


All of the above is a work of fiction. All resemblance to real events, situations, or persons, past, present, or future may or may not be purely coincidental.

Fiction to be read in relation to the last paragraph of Section 6 in my theoretical paper on "LIBOR Fallback and Quantititative Finance", Risks, 7(88), August 2019.


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