ICE Swap rate fallback - long expected - approximations

The Working Group on Sterling Risk-Free Reference Rates has proposed a document on the transition for GBP LIBOR ICE Swap Rate. Such a transition discussion has been required for a long time. See for example my post from 2019: ICE Swap Rate fallback?  and ICE Swap Rate fallback?

What is proposed is in line with what I explain to clients over the last years on what could happen. 

The proposal by the working group is a simplified approach as it try to approximate a complex situation where conventions are not the same between OIS and LIBOR swaps. Below is a slide from my standard presentation on the issue. Anything in red is different between the two world, i.e. every thing is different in term of dates and accrual factors. The only parts that are the same are the generic symbols for sums, forwards and discount factors. Unfortunately, once more, "LIBOR means LIBOR" cannot be considered as a true statement.

The proposal by the working group is a workaround due to a situation that is fundamentally incoherent. You cannot have a fallback for the ICE Swap Rate that is coherent with the fallback for LIBOR. A coherent mechanism can be created by a quant, but it requires a full curve calibration which is itself subjective (requires some form of interpolation). The conventions and payment mechanisms between OIS and LIBOR swaps create an absence of mapping between the rate coherent with LIBOR fallback and any simple derivation from OIS.

The proposition is summarised in the following extract from the document:

Some may consider this as a very complex mathematical formula that should not be used for a simple transition. But I want to attract the attention to the first words of paragraph 9: "The Approximation". Yes it is an approximation, not a fully coherent fallback procedure.

Moreover, the approximation does not take into account some features in the LIBOR fallback which includes a -2 day shift. The problem is not only day count conventions and frequency but also on the ON (SONIA) side the fact that the composition are not on the same periods. The formula (1) in the working group document does not indicate that this practical fact is taken into account in the analysis. This may make a significant difference around rate cut or hike dates. A change of 25 bps on 2 days is already a 0.14 bp impact on a 1 year rate. The figure in paragraph 24 in the document shows impacts well below that level for the 1 year rate. It means that the graph was not done with the actual fallback mechanism or not with realistic curves.

Today, any report (PV01, risk, etc) should include a distinction between rates coming from ICE Swap Rate and rates coming directly from LIBOR. LIBOR fallback can be different for different products/legal arrangements and anything related to ICE Swap Rate should be considered as a different product. Discounting and forward rate should appear on different curves if they are linked to ICE Swap Rates. A fallback risk reserve should be taken for the basis. Such a report, again extracted from standard presentations to clients, is proposed below (ICE Swap Rates exposures are in the red columns).

In the report, a cash settled swaption is perfectly hedged (from a sum of PV01 perspective) with a swap, but leaves a large basis risk. It means also that pull/call parity cannot be guaranteed for cash settled swaption (even with Collateralized Cash Price).

This is part of the VAT (Value Adjustment for the Transition) that I mentioned in several presentations and blogs.

Don't hesitate to contact me for advisory engagements related to interest rate modelling and benchmark transition. More details related to my work in the transitions can be found on my muRisQ Advisory website

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