2019-06-02

Fallback related documents

There was quite a lot of activity on the fallback side in the last weeks.

The deadline for the answers to the consultations is 12 July 2019. I encourage all to answer to the questions and to request all the required details about the important wording of the fallback that are still missing. Like for previous consultations, I plan to answer and will publish my answers when they are ready.

In the mean time, I have a couple of comments on the derivatiViews informal comments by ISDA's O'Malia. In particular two elements attracted my attention:

"That doesn’t mean the adjusted RFR will exactly match the relevant IBOR – it won’t, so there will be winners and losers. That’s another reason to act early and reduce or eliminate exposure to LIBOR."

"We continue to believe the best possible strategy is to take action early before a cessation of LIBOR, or before any potential decline in LIBOR liquidity."

"Once the alternative risk-free rate for euro – €STR – is published in October, we’ll conduct a separate consultation on the term and spread adjustments for euro LIBOR and EURIBOR fallbacks."

As describe for a long time on this blog, I also believe that there will be "Winner and losers", indeed. But acting early does not remove the winners and losers. The present value of derivatives is changed as soon as the pay-off is changed, there is no need to wait the payment date or the discontinuation date to feel the pain (or joy) of the loss (or gain). The tense used in the sentence (future) is the truth but not the whole truth. A more complete truth would be "there were, there are and there will be more winners and losers". A good amount of value transfer has already taken place, and from my perspective, I cannot judge if that has been done fairly. There will be more value transfer and I hope that no side will be allowed to take advantage of it.

On my side I continue to believe that taking action early is a good strategy, but simply acting now is in no way the "best possible" strategy. For the best possible strategy, it is too late. The best possible strategy was to act on the date the consultation results were published, i.e. on the 26 November 2018 (or before if you had any information about the likely results of the consultation) to align your positions with the value transfer implied by the results. This is what I did (on paper, as, personally, I don't have actual direct LIBOR exposures) on 27 November as described in a previous blog.

On the cessation date, the winners and losers will have been decided for a long time already. In derivative land, the present value is the expectation of the discounted pay-offs. The value thus changes as soon as you touch the pay-offs, i.e. as soon as you start discussing the changes in the fallback procedure. The value transfer started many month ago, and will be almost inexistent on the cessation date.

Why do we need to wait October and the publication of ESTER to have consultation on EUR fallback? The choice of the rate has been done, its methodology published and its starting date fixed. What extra information will we have on the 3rd of October? One fixing of the rate! How much more information do you have with that? Why do we need to wait? I would go as far as advocating (forward starting) trades on the benchmark and CCPs clearing them as soon as of tomorrow!

On the ARRC recommended fallback language for loans, we should notice again that the first step in the waterfall proposal is the SOFR term rate to be created. This isolate even more ISDA in not incorporating the term rate possibility in its consultations and not proposing a waterfall approach to fallback.

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