The Fallback supplement is here (or not)!

The new fallback supplement has been published by ISDA (Supplement 70 in Supplements to the 2006 ISDA Definitions). It is 107 pages long! It is very long but does not contain any information about the fallback mechanism itself!! Moreover the fallback mechanism can be changed at the caprice of a third party (or actually a fourth party) and it will cost you USD 20,000 or more a year!!! Even after reading it, I still don't understand what the fallback mechanism is!!!!

Before going through the different points, a little graph. If the meaning of the graph and its relevance to the fallback supplement is not obvious to you, I would advise you to read the supplement more carefully (or you can read here)!

107 pages long


This is a very long document. It contains many repetitions, for each currency and rate option, it is written in "legalese". One good point is that is contains some "fallback of fallback", i.e. what is happening if the planned fallback (like SOFR) does not exist anymore.

No information about the fallback mechanism


Even if it is very long, the text does not contain any description of the fallback mechanism itself. It is not in any way the text that was submitted to consultation. Several consultations took place, but they were certainly not about this text.

The central sentence of the fallback is (GBP version)

"Fallback Rate (SONIA) for the ‘Original IBOR Rate Record Day’ that corresponds to the Original GBP Fixing Date, as most recently provided or published as at 11:30 a.m., London time on the related Fallback Observation Day".

The text refers only to a "published" rate, not to a computed rate and does not provide any formula to compute that rate. What that publish rate is, is not fully clear to me (see below).

Caprice of a fourth party

The link to a rule for the computation seems to appear in the definition

(b)(u)  “Bloomberg IBOR Fallback Rate Adjustments Rule Book” means the IBOR Fallback Rate Adjustments Rule Book published by Bloomberg Index Services Limited (or a successor provider as approved and/or appointed by ISDA from time to time) as updated from time to time in accordance with its terms.”.

The interesting part is "as updated from time to time". Which means that Bloomberg has the power to modify the ISDA definition used in a bilateral contract between to unrelated parties. This is the "fourth party" caprice that I was referring to.

License trap

Just after the "as most recently provided or published", in the next sentence, there is a reference to "Bloomberg". This appears to be exactly the "license trap/troll" that I mentioned in a previous blog: "Would you pay 1,000,000,000 USD for public information?". With the new definition, you need, according to Bloomberg, a new license, i.e. a minimum of 20,000 USD yearly. A 1 billion revenue for Bloomberg as mentioned in my post.

The only silver lining is that the text only points to a rate that is "provided or published" but does not indicate by who it should be provided or published. I read in it (but I'm not proficient in the legalese language) that anybody can publish the rate. So maybe no need to pay the license, just publish the rate yourself. The definition (b)(u) reported above defines the Rule Book, but I have not find a place that says that the published rate should satisfies the rule book; I'm still looking for the link (see also below). 

It would be interesting to understand what compensation ISDA has received to write the supplement in this way, where it refers to a figure published (by a specific provider?) instead of including the relevant computation mechanism in the rules. 

What if someone want to challenge the computation done by Bloomberg that is not in accordance to the rules? Can he sue Bloomberg or ISDA?

I don't understand

What is hidden behind the "most recently provided". Is this some kind of workaround for the fact that the consulted fallback is ill-defined for some products like LIBOR in-arrears?

The relevant extracts seems to be

7.3.(t)  “Fallback Observation Day” means, in respect of a Reset Date and the Calculation Period (or any Compounding Period included in that Calculation Period) to which that Reset Date relates, unless otherwise agreed, the day that is two Business Days preceding the related Payment Date.
GBP-LIBOR 7.1.(i) If neither Bloomberg Index Services Limited (or a successor provider as approved and/or appointed by ISDA from time to time) provides, nor authorized distributors publish, Fallback Rate (SONIA) for that ‘Original IBOR Rate Record Day’ at, or prior to, 11:30 a.m., London time on the related Fallback Observation Day and a Fallback Index Cessation Effective Date with respect to Fallback Rate (SONIA) has not occurred, then the rate for the Reset Date will be Fallback Rate (SONIA) as most recently provided or published at that time for the most recent ‘Original IBOR Rate Record Day’, notwithstanding that such day does not correspond to the Original GBP Fixing Date. 

It seems to mean that you have a normal composition period, using the workaround of -2 business days described in the Rule Book. But if the rate for "normal" period rate is not available 2 business days before it is used (and this will happen very often as reported for a long time), the (ir)-relevant rate is simply the latest that is available? This makes a mockery of FRA, LIBOR in arrears, range accruals and even vanilla swaps with a week-end. With this approach, for some vanilla swaps, the overnight composition period will start 4 days before the original LIBOR accrual period!

I will investigate this last point further and add a new fallback option in my library: https://github.com/marc-henrard/muRisQ-ir-models/blob/master/src/main/java/marc/henrard/murisq/product/generic/FallbackType.java

I will try to understand the actual mechanism and I will report on my success to do so (if any). 

Personal conclusions

It is 107 pages long but does not contain any information about the fallback mechanism itself! Moreover the fallback mechanism can be changed at the caprice of a third party (or actually a fourth party) and it will cost you USD 20,000 or more a year!! Even after reading it, I still don't understand what the fallback mechanism is!!! 

Suggestions

Do not trade LIBOR products anymore. Convert the existing products to clean products at fair price. The OIS-like products resulting from the fallback are not clean (see graph above). For some products, e.g. LIBOR in-arrears, FRA, range accruals, and cap/floor, the fallback is destroying the original term sheet. The fair price of bilateral trades cannot be deduced from the quoted price of cleared trades. Don't sign the protocol, sign bilateral agreements tailor made to your need at a fair price. Use natural fallbacks that are not part of the ISDA definitions, e.g. EUR-EURIBOR for EUR-LIBOR and JPY-TIBOR for JPY-LIBOR.


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