Signing the LIBOR fallback protocol: a cautionary tale (again)

We are approaching the publication date for the new ISDA definition related to the IBOR fallback and the related protocole. Questions related to their impact are becoming more and more urgent. I was interviewed once more by Risk about those issues. Some quotes will probably appear in a Risk article in the coming days or weeks.

Here is a more extensive summary of my comments.

I'm starting with a graph without comment. If the meaning of the graph and its relevance to the protocol signature is not obvious to you, I would advise not signing the protocol! See my first cautionary tale about signing the LIBOR fallback protocol.


A robust fallback is important, the fallback embedded in the current ISDA definitions is not robust. Something need to be done about it, preferably before January 2022.

Where I disagree with the marketing barrage in favor of the ISDA protocol that we have seen recently is that the ISDA proposed fallback is the only one that is possible. I even disagree that the ISDA proposed fallback is actually robust, but that is another story that I have already discussed in many other posts (for example Fallback compounding in arrears won't work).

The full fallback wording has not published yet, it will be published on 23 October, and so the actual fallback details are still unknown. How can I agree with something that does not exists yet? It may exists for some people with material non-public information, but it does not exists for me.

It is important to indicate that the alternative to signing the protocol is not,  and has never been, "doing nothing". The alternative is to have a different agreement.

Signing before the discontinuation/trigger date has no financial advantage whatsoever. The only argument for an early signature is blackmail by regulator (serious questions) and "encouragement" by ARRC/ISDA, i.e. larger dealers.

The option to sign the protocol is an American option. Why would you exercise it early? Plenty can happen between now and discontinuation. There is no need to rush. What are the alternative to ISDA fallback?

  • EUR: fallback to EURIBOR
  • JPY: fallback to one of the TIBORs

I cannot understand why those obvious fallback were not part of the consultations.

  • GBP: SONIA term rate may exists before discontinuation (January 2022?), UK law synthetic LIBOR in under discussion.
  • USD: SOFR term rate may exists before discontinuation (January 2022?), IBA Bank Yield Index, Markit CDS-based credit spread, Duffie-Zhu across-the-curve credit spread, NY law synthetic LIBOR in under discussion.

Also, the ISDA fallback is not a change of rate or curve, it is a change of term sheet: the rate is settings in-arrears plus there is a two-day shift in period and potentially special cases for non-standard fixing.

The full and exact terms of the fallback have not been published yet. Users will need some time to review them in detail. The different ISDA consultations were on vague description for the composition period (LIBOR tenor period, then calculation period, then shifted period with ON calendar). The least that end-users will have to do is to check that your system can support the new term sheet, with all its special cases.

ISDA fallback spread is not fair. This was acknowledged by ISDA that explicitly said that there will be winners and losers. The spread is computed as the median of 5 years of historical data. To my opinion, a "fair" spread would be higher (and maturity dependent), specially now in this period of uncertainty. The median (by opposition to mean) has the impact of lowering the result. If you are receiver of LIBOR, negotiate the spread. Note: broker quotes are for clear swaps, not bilateral swaps. As such they are contaminated by the fallback at CCPs. They cannot be used to estimate the fair market value of a bilateral swap with their current fallback definitions.

A lot of buy-side/end users wonder if they should sign the protocol. What is the access of the decision making person (general counsel?) to advisor (internal or external) truly independent of their counterparties.?

ISDA documents with superficial description of the fallback can certainly not be considered as independent as ISDA is managed by its members, and in particular its larger members. The FCA blanket "advise" to sign at any cost cannot be considered as independent. The FCA is the regulator for "financial services firms and financial markets in the UK". Their point of view is the point of view of financial markets in general, not the point of view of the individual requirements of individual end users with respect to their personal constraints and needs.

I cannot understand how anybody could advise signing the protocole without an in depth analysis of the portfolio of the user he advises (counterparty exposure, hedging of other instruments, valuation, risks) without facing serious questions, on conduct risk in particular.

If there is a non-representativeness pre-cessation trigger, the derivative user can still check during/at the start of the pre-cessation period the level of fallback spread and the level of market spread. He can take the best for him. Why would he refuse a free option? Those signing early offer this free option. Someone refusing it will have serious questions to answer to his shareholders.

The long term value of the LIBOR fallback change value transfer is difficult to assess. This short pre-cessation period value transfer is easy to assess once we are in that period: the numbers are public, a simple difference and multiplication by the notional is enough. It will be easy and fair for all to look at it and blame the loss for signature on the decision maker (no gain is possible as at best you have achieve what was easily achievable at no cost).

The same reasoning can be done on the long term for EUR-LIBOR, comparing it to EURIBOR (see EUR-LIBOR fallback: Where is EUR-EURIBOR?)

My conclusion: Do something about the fallback. The first thing is to analyze all your options, including signing the protocol. Don't sign anything before you are sure of the impacts; there is no urgency before January 2022. Contact you counterparties to start the discussion about bilateral agreements.

Comments

Post a Comment

Popular posts from this blog

Multi-curve framework book: new edition in progress

Image
Subject: Interest Rate Modelling in the Multi-curve Framework: Foundations, Evolution, and Implementation It has been more than 10 years since I wrote the first edition of the multi-curve framework book. What happened in those 10 years? Why did it take me so long to start a new version? It took me roughly 10 years to write the first edition. The reason it took so long at that time, was that I did not know that I was writing it! I thought I was writing a couple of pages on an obscured and theoretical idea that there was not a `` one curve to rule them all '' but multiple curves. It turned out that it became the actual practice for very clear and important reasons. That was the excuse for the first edition, what is the excuse for the second edition? Since the first edition, many things happen, in particular: March 2015: BCBS - IOSCO: margin requirements for non-centrally cleared derivatives and mandatory variation margin July 2017: The future of LIBOR -- actually it...
Read more

Rigged: part 1 - Will there be a part 2?

Image
I have been reading book “Rigged: The Incredible True Story of the Whistleblowers Jailed after Exposing the Rotten Heart of the Financial” (Andy Verity, Flint, June 2023) for some time. It was published several month ago, but I just finished it. To my defence, I have to say that I don’t feel comfortable reading fiction where the “bad guys” are systematically winning by cheating. The book is the story of the miscarriage of justice done in the LIBOR manipulation story. The book content did not surprise me. For anybody having worked on a (swap) trading desk, it is clear that what was described by the accusation was impossible. It is not possible for some middle level trader to create a multi-year, multi-desk, multi-bank international conspiracy over open lines, broker lines, on open offices etc. without all around them, including compliance and senior management to be fully aware of what is going on. Moreover the regulators cannot be ignorant of the situation, except pleading complete in...
Read more

Treasury / Swap spreads are negative. And what?

In recent weeks there were several news articles related to the negative treasury/Swap spread. This is in particular the case of a Bloomberg article and a Zero Hedge blog . Some of the “information” in those notes are Swap rates are what companies, investors and traders pay to exchange fixed interest payments for floating ones. That rate falling below Treasury yields […]  is illogical in the eyes of most market observers, because it theoretically signals that traders view the credit of banks as superior to that of the U.S. government. It’s hard to overstate how illogical it is when swap spreads are inverted. That’s because it suggests that governments are less creditworthy than the very financial institutions they bailed out during the credit crisis just seven years ago. Let’s be clear, to me, those claims are purely wrong , nothing is “ illogical ” in negative swap spread. But why do I rant about that in the “multi-curve framework” blog? Because it is exactly the same that ...
Read more