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The cessation of LIBOR is a significant development for
financial markets. Two of the main remaining uncertainties around
the transition away from LIBOR to risk-free rates (RFR) are the
exact timings and, closely connected with them, the actual fixings
of the LIBOR fallback spreads. Despite COVID-19 disrupting many
market participants' preparation efforts, it is quite possible that
the original timeline will largely remain intact: relevant
authorities have urged market participants to be ready as soon as
possible [1] and a firm commitment of LIBOR panel banks to support
LIBOR will last only until the end of 2021. Whatever the case may
be, the clock is ticking. October saw another set of transition
milestones reached: the switch to SOFR discounting and SOFR price
alignment interest at clearing houses and ISDA's launch of the IBOR
Fallbacks Supplement and the IBOR Fallbacks Protocol, which will be
effective from 25 January 2021.
Arguably, the most anticipated event (or possibly events) of the
transition schedule is the LIBOR cessation trigger event which
precedes or concurs with the actual LIBOR cessation. The LIBOR
cessation trigger event is the announcement that a LIBOR has ceased
or will cease as of a particular date and has several implications.
For one, it could clarify whether there is a cliff edge transition
involving all LIBOR-tenor pairs simultaneously or a staggered
approach with different LIBOR-tenor pairs ceasing at different
times. A second and perhaps more pressing ramification is that the
LIBOR cessation trigger event also carries the weight of fixing the
LIBOR fallback spreads. This could cement any value transfer
associated with legacy contracts. A LIBOR cessation could
potentially be triggered as early as the end of 2020.
What LIBOR fallback spreads can be
expected?
The LIBOR fallback methodology defines the LIBOR fallback spread
as the median spread of a set of historical LIBOR-RFR basis spreads
recorded over a five-year lookback period. Start and end of this
lookback period are determined by the LIBOR cessation trigger event
(which sets the so-called spread adjustment fixing date) [2].
Assuming that the LIBOR cessation trigger event is not in the
too distant future, many or most of the basis spreads contributing
to the median calculation have already been observed. The range
within which the fallback spread must lie is thus already known to
a fair degree and tightens with each additional basis spread
observation. IHS Markit's Risk Bureau offers a simple tool to
investigate the fallback spread ranges for a selected set of LIBORs
and spread adjustment fixing dates, giving a historical view on the
expected fallback spreads. The tool also provides market-implied
basis spreads, which could be interpreted as the market's view on
the LIBOR fallback spreads and are derived from the valuation of
forward-starting ten-year LIBOR-RFR basis swaps. The tool is part
of a broader RFR impact analysis dashboard [3].
These spread estimates represent complementary views on the
final LIBOR fallback spreads and sooner or later both may be
expected to converge. Discrepancies, however, do exist and can be
read in different ways.
For example, Fig. 1 shows selected USD LIBOR fallback spread
ranges (shaded bands) associated with a relatively early cessation
trigger event. Overlaid are the market-implied basis spreads (solid
lines) for a similarly early swap start date. The historical
fallback spread bands narrow with time, as expected, and the
market-implied basis spreads appear to be roughly consistent with
the fallback spread bands. More recently, though, some of the
market-implied spread curves fall slightly outside the lower
fallback spread bounds. They also appear to be more strongly
impacted by this year's market turmoil than the fallback spread
bands, which is expected, too (for other currencies see [3]).
To understand this discrepancy, note that a meaningful
interpretation of the market-implied basis spreads in the context
of the LIBOR-RFR transition relies on the swap start date lying
past the LIBOR cessation date. This way the swap is sensitive only
to the longer-dated part of the LIBOR yield curve that is affected
by the LIBOR fallback. As the LIBOR cessation date falls on or
after the LIBOR cessation trigger date (spread adjustment fixing
date), which in turn sets the lookback period used in the fallback
spread range calculation, the discrepancy could be down to three
things:
The market is expecting a later LIBOR transition and cessation
timeline, much later than the spread adjustment fixing date and the
swap start date presumed in the Fig. 1. -- As a result, the
fallback spread ranges shown are too narrow.
The market is expecting a relatively large temporal gap between
the LIBOR cessation trigger event and the actual cessation of
LIBOR, during which the fallback spread is fixed but LIBOR is still
used and referenced. -- Assuming a later LIBOR cessation date (swap
start date) increases the market-implied basis spreads slightly and
brings them more in line with the fallback spread bounds.
A portion of the market hesitates to adopt ISDA's Fallbacks
Protocol and Fallbacks Supplement and prefers outright bilateral
solutions. -- In this case, the long-dated part of LIBOR yield
curves may only partially reflect the fallback spreads. The pickup
of ISDA's Fallbacks Protocol so far appears to be slower than
expected, with many market participants taking a wait-and-see
approach [4].
It is not too surprising that assuming an overall later LIBOR
transition timeline, both fallback spread bounds and basis spreads
become more consistent with each other again, see Fig. 2. Note that
varying the swap start date has only a moderate impact on the
market-implied basis spreads (typically, of a few basis points at
most).
Interesting times are ahead!
Figure 1 Market-implied fallback spreads and
historically derived LIBOR fallback spread ranges assuming an
earlier LIBOR transition timeline with coinciding LIBOR cessation
trigger and LIBOR cessation events.
Figure 2 Market-implied fallback spreads and
historically derived LIBOR fallback spread ranges for a later LIBOR
transition timeline with coinciding LIBOR cessation trigger and
LIBOR cessation events.
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