ARRC corroborates my cautionary tale on LIBOR fallbacks
On 6 March 2020, the ARRC published a document on a proposed legislative solution for the USD LIBOR contracts.
I read in the ARRC document the confirmation of the cautionary tale published published in Risk.Net a little bit that a month ago. The markets movements over the last days had already confirmed the legitimacy of such a caution. An updated version of the graph published in the tale is proposed below
I'm using two extracts of the document to justify the claim of the ARRC's confimation:
This is the starting point of my tale, the start of the "fiction" part of it. A fiction now corroborated by the ARRC. For ARRC also it is natural that the affected parties will ask an external arbitrator (the courts) for direction and naturally the arbitrator will base its decision on information available at the time of the decision (not only based on a very restricted set of information available at a prior date).
If the legislative proposal "increases consistency about the value of derivatives", it means that today, in the absence of it, there is no consistency about the value. This is the main argument of my cautionary tale: current non-cleared trades cannot be priced using only cleared market information. The ARRC text is implicitly saying that signing the protocol or law makers implementing the Legislative Proposal generates a value transfer between the market participants. I would go as far as to say that the ARRC proposing the legislative solution is already creating a value transfer by itself. The present value is the expected value of the (discounted) cash flows. By making the proposal, the ARRC is changing the probabilities of different cash flows to be realised, it is changing the expectation. The proposal itself is creating value transfers, as, in the past, the writing of ISDA consultations texts have created value transfers.
This is a real "value transfer", not a market movement or a missed trading opportunity. Market movement: it is not the economy moving or a policy decision that moves the market. The underlying real economy is not modified, what is modified is the contract terms. The economy is not modified by the fallback language, only the impact of the same economy on the contract is modified. Missed trading opportunity: the value transfer is not something that you choose to enter into or not, it is not the same as the decision of building a new factory or putting a proprietary trade. There are existing contracts with a clear, even if probably not achievable, description. The existing contracts are being modified by third parties, without control by all the contract parties. An equivalent in the insurance industry would be a legislation changing the definition of fire in the fire coverage insurance to say that oil burning is not considered as fire and keeping the insurance premium unchanged (and without allowing you to cancel the insurance and applying the new definition to current disaster claims). Would that be a market movement or a missed opportunity? None of the above, it would be a value transfer to the insurance industry.
Natural questions are: Who are the winners and who are the losers of the transfers created by the legislation? Will the transfers be compensated? If no, why? If yes, how?
On the legislative process, natural questions are: Will there be hearings about the proposal? If no, why? If yes, who will be the witnesses? Will there be a testimony from Fed or similar official about the impacts? Will the proposal and potential testimony be backed by research about its impacts?
Note: If you are a New York law maker, don't hesitate to contact me, I would be glad to share my opinions (backed by several years of research).
I read in the ARRC document the confirmation of the cautionary tale published published in Risk.Net a little bit that a month ago. The markets movements over the last days had already confirmed the legitimacy of such a caution. An updated version of the graph published in the tale is proposed below
I'm using two extracts of the document to justify the claim of the ARRC's confimation:
Alternatively, many parties would likely choose to litigate the outcome or otherwise ask the courts for direction.
This is the starting point of my tale, the start of the "fiction" part of it. A fiction now corroborated by the ARRC. For ARRC also it is natural that the affected parties will ask an external arbitrator (the courts) for direction and naturally the arbitrator will base its decision on information available at the time of the decision (not only based on a very restricted set of information available at a prior date).
It would increase consistency across derivatives markets about the value of derivatives linked to U.S. dollar LIBOR.
If the legislative proposal "increases consistency about the value of derivatives", it means that today, in the absence of it, there is no consistency about the value. This is the main argument of my cautionary tale: current non-cleared trades cannot be priced using only cleared market information. The ARRC text is implicitly saying that signing the protocol or law makers implementing the Legislative Proposal generates a value transfer between the market participants. I would go as far as to say that the ARRC proposing the legislative solution is already creating a value transfer by itself. The present value is the expected value of the (discounted) cash flows. By making the proposal, the ARRC is changing the probabilities of different cash flows to be realised, it is changing the expectation. The proposal itself is creating value transfers, as, in the past, the writing of ISDA consultations texts have created value transfers.
This is a real "value transfer", not a market movement or a missed trading opportunity. Market movement: it is not the economy moving or a policy decision that moves the market. The underlying real economy is not modified, what is modified is the contract terms. The economy is not modified by the fallback language, only the impact of the same economy on the contract is modified. Missed trading opportunity: the value transfer is not something that you choose to enter into or not, it is not the same as the decision of building a new factory or putting a proprietary trade. There are existing contracts with a clear, even if probably not achievable, description. The existing contracts are being modified by third parties, without control by all the contract parties. An equivalent in the insurance industry would be a legislation changing the definition of fire in the fire coverage insurance to say that oil burning is not considered as fire and keeping the insurance premium unchanged (and without allowing you to cancel the insurance and applying the new definition to current disaster claims). Would that be a market movement or a missed opportunity? None of the above, it would be a value transfer to the insurance industry.
Natural questions are: Who are the winners and who are the losers of the transfers created by the legislation? Will the transfers be compensated? If no, why? If yes, how?
On the legislative process, natural questions are: Will there be hearings about the proposal? If no, why? If yes, who will be the witnesses? Will there be a testimony from Fed or similar official about the impacts? Will the proposal and potential testimony be backed by research about its impacts?
Note: If you are a New York law maker, don't hesitate to contact me, I would be glad to share my opinions (backed by several years of research).
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