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One major problem to tackle in the transition from LIBOR to
alternative reference rates (ARRs) such as SOFR, €STR and SONIA
(which are also referred to as risk-free rates, or RFRs) is how to
handle legacy LIBOR positions when LIBOR is no longer published. It
is fundamentally a challenging issue. While LIBOR is a
credit-sensitive rate, the new risk-free ARRs such as SOFR are
risk-free rates without a credit component. However, with the ISDA
Fallbacks Protocol the problem is largely resolved. Or is it?
The mechanics of the ISDA protocol is now well understood for
vanilla swaps. After the cessation of the relevant LIBOR fixings
(e.g., GBP 6M LIBOR) referenced by legacy positions in a portfolio,
each LIBOR fixing will be replaced by its replacement ARR such as
SOFR, €STR and SONIA with an adjustment spread that is
pre-determined for each LIBOR fixing. Since the new rates are daily
rates, they will be compounded through the coupon period to form a
term rate in time for payment (i.e., by the Cut-off Time such as
two days prior to the payment date). If the forward LIBOR rates are
traded, prior to cessation, at levels consistent with the ARR
forwards plus the ISDA fallback spread, the application of the
Protocol will not result in value transfer.
The situation surrounding non-linear derivatives is much more
complicated. By design the ISDA Fallbacks Protocol is meant for all
products. Therefore, it can handle non-linear products including
LIBOR exotics, which increases the utility of the Protocol as a
safety mechanism. However, the Protocol may or may not produce a
desirable outcome. So, the following questions must be asked:
Can the protocol procedurally work for a given
trade?
Will the 'fallen back' trade be economically equivalent to the
original trade?
The answer to the first question is a reassuring yes in most
cases. The protocol can transform even those products whose
LIBOR-linked payoffs do not seem naturally compatible with
compounded-in-arrears rates. However, the fact that the Protocol
can successfully render a LIBOR trade into an 'equivalent' one that
references an ARR does not mean that the resulting new ARR trade is
economically similar, let alone equivalent, to the original trade.
In the case of some LIBOR exotic trades, the Protocol can totally
alter the economics of the trade. Let's look at a few examples.
Swaption
The fallback protocol works well for swaptions with all
settlement variations. For a physically-settled swaption, the
existence of the Protocol means that the underlying LIBOR swap can
be deemed equivalent to an ARR swap with a fallback spread (e.g.,
10-year SONIA swap with a spread on the compounded SONIA rate).
Therefore, a physically-settled LIBOR swaption becomes economically
equivalent to a swaption to enter into an ARR swap with a spread on
the floating rate. By moving the spread on the floating leg onto
the fixed leg, a legacy LIBOR swaption that is physically-settled
can be shown to be equivalent to an ARR swaption (e.g., SONIA
swaption, SOFR swaption, etc), with a suitable adjustment on the
fixed coupon rate, or the strike level.
There are some minor caveats, however. If the original term
sheet specifies that the underlying swap is cleared but the legacy
LIBOR swap is no longer eligible for clearing when the fallback is
applied, then the swaption must be settled in cash following the
Collateralized Cash Price method.
Cash-settled swaptions can be treated in a similar fashion
because the transformation of the underlying swap will essentially
be the same. The main issue is with the publication of the
benchmark rate such as the ICE Swap Rate (formerly known as
ISDAFIX) for the underlying legacy LIBOR swap. Since ICE Swap Rate,
which is for LIBOR swaps, will (most likely) stop being published
after LIBOR is retired, an alternative method must be established
to determine the settlement amount.
To date, both ARRC and the Working Group on Sterling Risk-Free
Reference Rates have proposed a formula to produce an approximate
value of the discontinued ICE Swap Rate for a LIBOR swap from the
corresponding RFR ICE Swap Rate. It is anticipated that the
industry will embrace these formulae for the settlement of legacy
LIBOR swaptions. If the market participants believe that these
formulae produce results that are consistent with the present
values of corresponding underlying legacy LIBOR swaps to which the
ISDA Protocol is applied, the pricing of cash-settled swaptions
(using Collateralized Cash Price) will not attract any additional
valuation adjustments.
Cap/Floor
The situation is more involved with caps and floors. While the
fallback protocol can replace the underlying LIBOR rate with a new
rate such as SOFR and €STR in the same fashion as vanilla swaps,
the difference in the timing of rate fixing alters the economics of
the trade. Unlike the conventional LIBOR cap/floor, the payoff of a
new ARR (or RFR) cap/floor is not determined until the end of
(e.g., two days prior to) the coupon period. In other words, a
LIBOR cap (or floor) gets transformed into a compounded-in-arrears
ARR (or RFR) cap/floor. This has two implications: (1) the
time-to-expiry gets extended and therefore the option value will
increase; (2) the payoff will become dependent on multiple (daily)
fixings, so a LIBOR cap (or floor) will become an Asian option in
respect of the daily rates. RFR cap/floors must be valued
considering these features that are distinct to them. In
conclusion, while the Protocol will work well procedurally for caps
and floors, it alters the economics of the trade and cause value
transfer.
The volume of RFR cap/floors is still limited. But markets are
evolving as methodologies for these new cap/floors have been
proposed, and major broker-dealers gradually increase their trading
of this new instrument type.
LIBOR-in-arrears (LIA)
LIBOR-in-arrears swap is one of the classic variations of the
vanilla interest rate swap. Unlike the vanilla interest rate swap,
the floating rate is fixed at the end of the reset period. As the
swap references LIBOR at a later date (e.g., 6 months later on a
semi-annual LIA), it allows the investor/hedger to take a view on
the future changes in the slope of the yield curve (together with a
consideration for convexity).
Since there is no gap between rate fixing and payment, the
structure of the swap is not suitable for the use of an
arrears-fixing rate. However, Section 6(d)(i) of the ISDA Fallbacks
Protocol provides language that allows the determination of a
fallback rate nevertheless. The following text from the
accompanying FAQ document describes the provision in a slightly
more accessible fashion:
"However, if a Calculation Period is shorter than the length
of the Designated Maturity (for example, if 6-month sterling LIBOR
was originally to be used for a four month Calculation Period),
then the fallback rate for the 'Original IBOR Rate Record Day' that
corresponds to the Relevant Original Fixing Date would not be
published/provided by the Applicable Cut-off Time such that the
most recently published fallback rate for the most recent Original
IBOR Rate Record Day will be used instead."
In short, if a compounded-in-arrears fallback rate cannot be
formed because there is not enough time between the LIBOR fixing
date and the cut-off date (e.g., two business days prior to the
payment date), the Protocol will use the most recent rate that is
known by the Cut-off Time. But the brute force application of this
rule will have the effect of degenerating a LIA into a vanilla
interest rate swap. That is ironical.
In other words, although procedurally the ISDA fallback works
with LIA, the economics of the trade will be entirely altered. As a
result, the fallback protocol will cause value transfer for legacy
LIA positions. More fundamentally, LIA's product design is not
sustainable post LIBOR retirement. It is likely to stop trading in
the future in the absence of LIBOR.
Range accrual
This is yet another popular LIBOR exotic product, which has been
in existence for multiple decades. In a range accrual trade, the
coupon accrues only on days when the relevant LIBOR is within a
pre-determined range (e.g., 0-3%). Since the daily observations of
the relevant LIBOR are used for the calculation of the coupon
amount, the fallback protocol must prescribe how each of the daily
LIBOR fixings should be replaced with the ARR (with a suitable
spread).
However, except for the very first LIBOR fixing, no replacement
compounded-in-arrears rates can be used because they are not known
in time by the Cut-off Time (e.g., two days prior to the coupon
payment date). So, the provision we cited for LIA is invoked again
to resolve the issue. As a result, from the second fixing onwards
the "last known fallback rate" is used for the determination of the
range accrual coupon amount. In other words, the same fallback
rate, which essentially corresponds to the LIBOR fixing set at the
beginning of the reset period, is used as the replacement rate for
all the daily fixings.
As a consequence, a range accrual will fall back to become
economically equivalent to a single-look LIBOR range bet (or a
combination of a LIBOR cap and a floor from a risk perspective).
Due to the change in the economic properties, the fallback will
trigger value transfer. The averaging effect of daily fixing will
be lost, and the timing of fixing will be brought forward, which
will bring the effective forward fixing levels lower in an upward
sloping curve environment.
Issues with range accruals do not end there. Since there is no
strict standardization of language used to describe range accrual
trades, some term sheets that are not documented under the ISDA
range accrual template might not be able to apply the fallback.
The only way to remove these uncertainties is to bilaterally
negotiate a mutually agreeable conversion of the existing positions
into alternative trades. While there is no consensus on the future
format of range accruals, possibilities include (1) using the daily
RFR rates for accrual calculation (without any compounding), (2)
using short swap rates such as CMS 1Y instead of LIBOR as a
reference index. However, since all these alternative payoffs will
have a risk and valuation impact, ample time should be allocated to
review the details thoroughly and to agree appropriate new terms to
avoid inadvertent value transfer.
Conclusion
Having reviewed the potential consequences, it is evident that
simply letting the ISDA Fallbacks Protocol handle legacy non-linear
LIBOR positions is not going to guarantee a desirable outcome. Even
for vanilla swaps, the industry best practice is to proactively
convert legacy IBOR swaps ahead of LIBOR cessation so that the use
of ISDA Protocol is minimised. Clearinghouses such as LCH and CME
are converting existing LIBOR swaps en masse into RFR equivalents
ahead of 31 December 2021. If vanilla trades require this much
attention to avoid surprises, why shouldn't non-linear trades that
are fundamentally more complex deserve more attention?
Undoubtedly, the value of the ISDA Fallbacks Protocol for the
industry is immeasurable. But it is only a seatbelt. Although a
seatbelt increases the chances of survival in the event of a car
crash, it does not help avoid a crash. Why should a firm leave
things to chance instead of proactively converting legacy LIBOR
positions, especially non-linear positions, into ARR equivalents on
terms that make sense economically?
Vladimir Piterbarg, February 2020, "Interest Rates Benchmark
Reform and Options Markets", SSRN
Sander Willems, March 2021. "SABR smiles for RFR caplets",
Risk.net
Posted 20 May 2021 by Hiroshi Tanase, Executive Director
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