Another big bang: CCPs steers away from ISDA fallback

LCH has published a new circular related to the transformation of LIBOR related contracts at cessation.

I commented earlier on the issues in my post Wow! - LCH plans Libor swap switch to RFRs and CME steers away from ISDA fallback.

With the further document published by LCH, a further discussion on the subject appears timely.

Before discussing the LCH solution, we should review why we are there. The need of a "solution" is because the fallback proposed by ISDA is ill-conceived from a risk management perspective. This is not a surprise. The different consultations and analysis have probably been done from a legal point of view but from the start the risk and valuation aspect has been neglected. I have been one of the first, but certainly not the only one, to point to those issues. My blog from 26 July 2018 (Consultation on IBOR fallbacks: Question 1) already points at the issues that will lead to the need of a "solution" from LCH.

After that original fallback sin, on ISDA side, the second sin has been on the CCP side. They have said in a vague way that they will implement the ISDA fallback without knowing what that fallback would be and without knowing if they would be able to actually implement it. Now we have answer to the two unknowns: ISDA (or more exactly Bloomberg) has published the details of the proposed fallback and the CCPs are not able to implement it.

After having described those two initial sins, we can now try to understand the situation we are in.

The choice of not following the ISDA fallback is not surprising. As mentioned in my previous blog on the subject, I have been advising my clients to negotiate a similar solution with their conterparties for some time. I used in some discussion the terminology "complex resulting Frankenstein-like OIS in the fallback." I still believe it is the most appropriate description. The blog on "Gap and overlaps" explains why "Frankenstein-like OIS" is appropriate.

The market, after having better understood the mistake they allowed through the ISDA "consultations", naturally voted here for a conversion of trades without going through the fallback. The answer is a contradiction as the "market" has, according to the ISDA consultation, agreed on a consensus for the fallback but immediately after has, according to the LCH consultation, agreed not to apply it. It sounds like "I have done a mistake, let's correct it before it is too late" and not a "I'm convinced on my first decision".

This conversion of LIBOR trades at cessation effective date leaves open an important question: what is happening after that date to LIBOR swaps. This is not a trivial question and certainly not without merit. One may claim that all the swaps have been converted and nothing more is needed, but this is far from being true. There exists LIBOR swaps that are not cleared on the cessation date and that will need to be cleared after, in particular swaps resulting from swaption exercises and swaps where a forward clearing has been agreed between the parties. Remember the issue with the "discounting big bang" and swaptions. Will we have the same here, but in worst? Not only the trade may change value but maybe we will have a "an-unstoppable-force-meets-an-immovable-object" situation. Swaps resulting from swaptions exercise have to be cleared but no clearing house accepts them. A full big bang is not what we need, we need a long term solution that may include a "large but not too big" bang.

According to LCH consultation, the spread resulting from the spread adjustment would stay in the swap on the floating leg. That seems the most clean approach, from a risk and valuation (and probably accounting) perspective. The existence of those spreads may have an impact on compression. Up to now, compression is based on "blended coupon" type approach on fixed legs. With a spread on some floating legs and not on others, the floating legs are not fungible anymore. Some kind of "blended spread" method would be needed. To my knowledge, this has not been implemented by CCPs.

The idea of converting the trades is good for me. The part that I don't know about is the legal part of it. Can the CCP forced its participants to accept this change of trade description? I know that LCH rule 1.8.12 states: "[...] the Clearing  House  will determine an alternative rate at its sole discretion." But determining a rate on the fixing date is different from changing a forward looking rate into a backward looking rate and is also different from the "termination of the LIBOR contract and re-booking as an RFR contract". This is even more true if cost is involved like in "we intend to apply a fee for contracts which experience a cessation event and/or which are subject to the conversion process".

The circular (Step 04) mentions "cash compensation is applied to neutralise any small residual valuation difference". I guess that is the difference coming from the change of dates between the fallback and the OISs. There is no indication on how this would be computed. I guess that CCPs will need to implement a mechanism similar to the "Fallback Transformers" (see Fallback Transformers and the other 9 installments linked there). The impact of the fallback is not a curve change, it is a contract change with many idiosyncrasies is important. The CCPs have not indicated how they will implement those contract changes in practice for valuation purposes. LCH has explicitly said that the absence of big bang "may undermine confidence in [their] default management capabilities". How can we have confidence in the CCP capacity to "neutralise any small residual valuation difference" in this context?

In parallel, all the market participants that have traded LIBOR swaps after 25 January 2021 or have signed the LIBOR fallback protocol have to review their risk management. With this "large bang", new basis risks appear, serious questions have to be asked on the valuation and risk side.

My advise for any market participant going through the transition, and a big bang style transition in particular, is to seek specialised independent advise in the risk and valuation impacts. This applies to CCP big bangs but also to bilateral changes to CSAs. Most of the times, the documents produces by the different parties involved (associations, CCPs, brokers, etc.) lack depth and in some cases I would say they are misleading. If you are spending many millions on the LIBOR and overnight transitions, it is certainly worth spending a couple of thousands on high quality independent advise. You may not agree with all the advises or suggestions you will receive but at least you will have a perspective on the different point of views and potential impacts of decisions.

Added 2021-02-28: Risk has published an article on the LCH proposal: Swaps users shun cash compensation in LCH Libor switch (subscription required). The article is partly based on background information I provided to the journalist.

It is interesting that one of the question I was asking, the one regarding the blended spread, has been answer. Unfrotunately for the market the answer is negative:

“What’s important for blended rate compression is that you’ve got everything lined up between two contracts apart from the fixed rate itself,” says Whitehurst.

I was expecting some blended spread mechanism to be implemented on overnight legs. This would be exactly the same mechanism that on the fixed leg. But from the LCH's answer it appears that the CCP system does not support it and their is no plan to implement this simple and useful mechanism. One further fragmentation in the market!

On the other side, the article confirms that there is a change of terms for the trades:

LCH’s conversion plan will change the legal terms of converted trades to align with standard OIS contracts.

I don't know which power the CCPs have to change the terms of existing trades and what is the potential extend of acceptable changes.

On the EONIA side, the article confirms what I guessed in a previous blog: Wow! - LCH plans Libor swap switch to RFRs. LCH cannot deal with the fixed ESTR-EONIA spread on overnight rates. Remmeber that the same LCH said that "However, I don’t believe that’s problematic: our primary concern is to manage risk, and in this instance – thanks to the fixed spread – all the dynamics of forward-€STR can be captured through forward-Eonia, and vice-versa." That appears to be no completely true as

spread-inclusive compounded trades are not eligible at LCH

This is no surprise for me as my expectation is that EONIA derivative users will either convert their EONIA trades or keep EONIA "synthetic" fixing and curves in their systemes for many years. I still have to meet someone that tells me that his institution with apply the EONIA to ESTR fallback as described in ISDA supplement precisely, i.e. no EONIA fixing or curve in the system, fixed 8.5 bps basis point applied on the overnight rate and not approximation.