Pre-cessation trigger consultation: here we go again!
Pre-cessation trigger consultation: here we go again!
ISDA has launched yesterday a second consultation on pre-cessation fallbacks. The first consultation did not provide the results the Power from Above wanted, so here we go again.
My answer is below. It is a summary of arguments I have made in previous article and blogs. I may improve the wording before sending it to ISDA. If I do so, I will update this blog accordingly.
When analysing transaction in LIBOR derivatives we obviously do so in part for the LIBOR exposure of such transactions, that exposure includes credit and liquidity components. If the goal is to trade overnight benchmarks interest rate risk, we analyse direct trades in overnight-linked derivatives and we don't do it through a fallback proxy. The reduce exposure to LIBOR due to the pre-cessation trigger is a deterrent to use LIBOR derivative and not an improvement to the definitions.
To achieve the required exposure on new trades, the fallback has to be trigger as late as possible. Any pre-cessation trigger is a negation of the trade existence itself. The LIBOR fixing, even if not perfect or deemed not representative by a third party — e.g. a regulator — is better than a fixing based on a RFR plus a spread which is not credit and liquidity dependent. Fallback should be a last resort mechanism and used only in last resort. The pre-cessation event is not an event requiring last resort. The estimation by a single entity, even a regulator, without review and recourse mechanism in place, regarding a major interest rate standard that has been working for more than 30 years and is still working, should not be consider as a case of last resort.
The pre-cessation creates a difference between legacy trades and trades to which the protocol is applied. The application of the protocol will result in value transfers. As Scott O'Malia puts it, the ISDA fallback creates losers and winners. The value transfers need to be estimated and a compensation must be agreed between the parties before entering into a bilateral contract leading to the application of the new definitions. Due to the transfers, some counterparties are losers and other winners. The protocol, which is applied to all adherents without direct bilateral agreement, is not an efficient mechanism in this case. The acceptance of new fallback mechanism, including the decision to use the pre-cessation mechanism or not, needs to be flexible and done counterparty by counterparty or, even better, trade by trade.
A mandatory pre-cessation trigger in the new definitions would unavoidably harm the possibility of a bilateral agreement resulting in the application of the new definitions. It would unavoidably harm end users with legacy trades as it would require further investigation, estimation and negotiation with all counterparts in existing trades.
More technical details are available in Henrard (2020).
The new definitions should include the pre-cessation trigger only as a voluntary option, to be negotiated bilaterally, potentially on a trade by trade basis. Including this as an option would allow the market participants who do not want these combined pre-cessation and permanent cessation fallback provisions to achieve it within standard ISDA Definitions and related Protocol. If the pre-cessation trigger are mandatory, participant will require to develop bilaterally negotiated terms outside of the ISDA Definitions.
Note (2020-03-08): The text has been very slightly modified with respect to the text published on 2020-02-26. The changes are spelling errors and clarification of some sentences.
A couple of questions related to the consultation wording (question sent to ISDA):
The question refers only to LIBOR. Does that mean that the pre-cessation trigger will only apply to LIBOR and not to the other IBORs?
The question explicitly mention the FCA. Does that mean that if the non-representativeness of the LIBOR is announced by another government body, the benchmark regulator changes or the FCA changes its name, then the pre-cessation trigger will not apply?
Henrard, M. (2020). Fallback protocol signature: a cautionary tale. Risk.Net. Published on-line 21 January 2020 at https://www.risk.net/comment/7351246/signing-the-libor-fallback-protocol-a-cautionary-tale (subscription required).
ISDA has launched yesterday a second consultation on pre-cessation fallbacks. The first consultation did not provide the results the Power from Above wanted, so here we go again.
My answer is below. It is a summary of arguments I have made in previous article and blogs. I may improve the wording before sending it to ISDA. If I do so, I will update this blog accordingly.
ISDA Question (summary):
Should ISDA publish a Supplement to the 2006 ISDA Definitions so that the Rate Options for LIBOR all contain fallbacks that would apply upon the first to occur of (i) a permanent cessation trigger or (ii) a ‘non-representativeness’ pre-cessation trigger?
Answer:
NO
Additional explanations:
In the current master agreements, the only event that leads to a fallback is the non-publication of the rate, there is no notion of announcement date and even less pre-cessation trigger. A pre-cessation trigger forces extra complexity and increases the fragmentation of the market. Legacy trades only have non-publication as a trigger, adding a pre-cessation trigger create a discrepancy between the trades under the new definitions and the legacy trades. The discrepancy would make it more complex to hedge the legacy book. A new fragmentation of the market will be created.When analysing transaction in LIBOR derivatives we obviously do so in part for the LIBOR exposure of such transactions, that exposure includes credit and liquidity components. If the goal is to trade overnight benchmarks interest rate risk, we analyse direct trades in overnight-linked derivatives and we don't do it through a fallback proxy. The reduce exposure to LIBOR due to the pre-cessation trigger is a deterrent to use LIBOR derivative and not an improvement to the definitions.
To achieve the required exposure on new trades, the fallback has to be trigger as late as possible. Any pre-cessation trigger is a negation of the trade existence itself. The LIBOR fixing, even if not perfect or deemed not representative by a third party — e.g. a regulator — is better than a fixing based on a RFR plus a spread which is not credit and liquidity dependent. Fallback should be a last resort mechanism and used only in last resort. The pre-cessation event is not an event requiring last resort. The estimation by a single entity, even a regulator, without review and recourse mechanism in place, regarding a major interest rate standard that has been working for more than 30 years and is still working, should not be consider as a case of last resort.
The pre-cessation creates a difference between legacy trades and trades to which the protocol is applied. The application of the protocol will result in value transfers. As Scott O'Malia puts it, the ISDA fallback creates losers and winners. The value transfers need to be estimated and a compensation must be agreed between the parties before entering into a bilateral contract leading to the application of the new definitions. Due to the transfers, some counterparties are losers and other winners. The protocol, which is applied to all adherents without direct bilateral agreement, is not an efficient mechanism in this case. The acceptance of new fallback mechanism, including the decision to use the pre-cessation mechanism or not, needs to be flexible and done counterparty by counterparty or, even better, trade by trade.
A mandatory pre-cessation trigger in the new definitions would unavoidably harm the possibility of a bilateral agreement resulting in the application of the new definitions. It would unavoidably harm end users with legacy trades as it would require further investigation, estimation and negotiation with all counterparts in existing trades.
More technical details are available in Henrard (2020).
The new definitions should include the pre-cessation trigger only as a voluntary option, to be negotiated bilaterally, potentially on a trade by trade basis. Including this as an option would allow the market participants who do not want these combined pre-cessation and permanent cessation fallback provisions to achieve it within standard ISDA Definitions and related Protocol. If the pre-cessation trigger are mandatory, participant will require to develop bilaterally negotiated terms outside of the ISDA Definitions.
Note (2020-03-08): The text has been very slightly modified with respect to the text published on 2020-02-26. The changes are spelling errors and clarification of some sentences.
A couple of questions related to the consultation wording (question sent to ISDA):
The question refers only to LIBOR. Does that mean that the pre-cessation trigger will only apply to LIBOR and not to the other IBORs?
The question explicitly mention the FCA. Does that mean that if the non-representativeness of the LIBOR is announced by another government body, the benchmark regulator changes or the FCA changes its name, then the pre-cessation trigger will not apply?
Henrard, M. (2020). Fallback protocol signature: a cautionary tale. Risk.Net. Published on-line 21 January 2020 at https://www.risk.net/comment/7351246/signing-the-libor-fallback-protocol-a-cautionary-tale (subscription required).
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