Fallback and protocol: some comments
Since the publication of my latest blog on the ISDA fallback and the associated protocol, I had several discussions about my views and many articles and opinions have been published. In this blog I detail further my (biased) views and also comment on some quotes I have read recently.
Preliminary version (2020-11-15).
This post is longer that the traditional one because
Je n'ai fait celle-ci plus longue que parce que je n'ai pas eu le loisir de la faire plus courte.Blaise Pascal - Les provinciales, lettre 16 (1656)
There is a lot to say about LIBOR potential disappearance and associated fallbacks. The need of a better fallback that the one currently in the ISDA definition is acknowledged by all. The current (as of November 2020) ISDA definition fallback is not fit for purposes.
ISDA has proposed new definitions that will be effective next year. It also proposed a protocol that would allow market participants to voluntarily change the definition of the legacy contracts (i.e. contract signed before January 2021) to the new definitions. The term "voluntarily" above is very relative as the CCP have announced that for cleared derivatives the change will be mandatory. As there is a mandatory clearing regulation in place in many jurisdiction, the voluntary part is becoming forced for most.
This blog is about the protocol and its voluntary signature for bilateral contracts.
Here also the voluntary term is very relative. In particular in the UK, the FCA has insisted that parties not signing the protocol will face "serious questions" from the regulator, an official blackmailing propaganda that I have already commented on in Marketing barrage on signing ISDA Fallback Protocol.
My point of view can be summarised in a couple of items:
- change of contract term and change value
- voluntary
- many alternatives, often better for the users
- Timing / no urgency
- Legal aspects
Changes
The changed brought by the fallback are not trivial. They create contract with significant differences in payoffs and change of values. The changes in values, embedded by the infamous adjustment spread, are non trivial.
Saying that the spread choice is fair is equivalent to say that the curves representing spreads in the graphs below are horizontal lines.
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.
Further comments on the legal side of the issues where provided by different contract law expert in a recent article published in Libor fallback protocol: the X factor (Practice Insight, subscription required). I propose a couple of quotes below
“Adherence may not be in any individual party’s best interests, and any pressure placed on counterparties to adhere could potentially lead to claims down the road,” said Guy Usher, partner and head of derivatives practice at Fieldfisher.
Some advise to blindly and quickly adhere and then negotiate. The adherence crystallizes the value transfer embedded in the new definitions. So when you have signed you loose any negotiation ability on the value. Also it may make you counterparty less willing to negotiate on the risk management side as you will probably fall at the bottom of the pile of urgency. Again this is not true only on the quant side but also the legal side.
“Is it the wonder solution, or does it hide a host of issues?” said Usher. “There are plenty of things to think about before adhering. I’m sure take up will be high eventually, but it’s not something to rush into without proper analysis.”
Negotiating the spread or other features is not a way to make money unethically, this is a way to obtain the actual value of the original contract. It is the signature of the protocol that has to be seen as a potentially unethical way to change the will of the parties at the original contract signature.
Voluntary
The alternative to the protocol has never been "do nothing" contrary to what some try to pretend. The alternative to the protocol as I support it is "do better".
Edwin Schooling Latter, head of markets policy at the UK’s Financial Conduct Authority (FCA), said at an online industry event. “It is now up to market participants to take this up. Not signing the protocol seems like a huge risk that firms cannot afford to take. Anyone who doesn’t should be prepared to face serious questions and should have solid mitigating plans in place.”
The amazing thing in this quote is the last "and". It appears it is not enough to have "solid mitigating plans". Even if you have a perfect plan, you will still face serious questions. But it sounds like if you sign the protocol, don't understand it and leave the risk associated to the fallback mechanism open, it is not an issue from a regulatory point of view.
I have already pointed to the logical fallacy of the FCA comments in a previous blog: Marketing barrage on signing ISDA Fallback Protocol.
In a recent comment to the the Senate Banking Committee, Vice Chair Quarles said "There are a variety of ways, within the next month or two, we should have a plan to share that would address that. We need to consider a mechanism that would allow so-called legacy contracts, the great bulk of them, to mature on their existing basis without having to be renegotiated and shifted to a new rate". This means that protocol, which shift to a new rate, should not be the default approach.
Alternatives
I regular question I receive, in some form or another, is what practical options do you have? Is this simply the protocol plus some kind of "fair" spread adjustment?
The answer to that type of question is that if you sign the protocol, there is no practical options anymore.
Outside the protocol there is an infinity of possibilities. They apply to the "losers" in a monetary sense but also the "losers" in an operational or risk management sense.
- Restructure LIBOR derivatives. Even with OIS, the replacement will be better as the gaps and overlaps are avoided, see Fallback transformers: gaps and overlaps. Doing that, you already save 20,000 USD annually in license fees! But more importantly you have a clean book.
- Have meaningful rules for derivatives which are structurally changed by the fallback: cap/floor, LIBOR in-arrears, FRA, range accrual. See e.g. Piterbarg "Interest Rates Benchmark Reform and Options Markets"
- Move to physical settlement when meaningful. See LIBOR Fallback: is physical settlement an alternative?
- Wait for alternative rates to appear. This can be term rates or credit sensitive rates. Bloomberg recently joined the list of would-be provider after IBA USD Bank Yield Index / AMERIBOR (AFX) / HS Markit dynamic credit spread (CDS) / AXI index (Duffie) / Constant Maturity Treasury (Tradeweb/IBA) / Bloomberg. See Risk.Net article (subscription required): Bloomberg joins race for SOFR credit add-on
- Change the way the spread is applied. The fallback will create issues with spread and composition, e.g. a "flat compounding" will require to compound the fallback spread but not the original spread. Is that supported by the risk/valuation systems?
And any of this need to be done at a fair price, another infinity of possibilities to structure the price (spread, up-front payment, coupon adjustment, etc.).
FCA has repeated that banks need to "treat customers fairly". This would mean that a bank cannot refuse to its customers to discuss those possibilities and for them to chose the "fairer" option. Advising an end user to sign the protocol without an in depth analysis of its portfolio, its options and its risk management tools, would certainly not qualify as "fair".
If you don’t adhere to the ISDA protocol you’re going to court.David Bowman, US Federal Reserve senior associate director
This is plain wrong! And he knows it, as a little bit later he says "If you’re not going to adhere, you need to close out or renegotiate those derivatives". Again the alternative to not signing is not doing nothing and certainly not "going to court".
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