Upcoming ISDA Fallbacks Highlight Need for Right Solution to Manage the LIBOR Transition

Paris, France - January 27, 2021

by Didier Loiseau, global head of rates, bonds and credit

The bulk of USD 400 trillion of financial derivatives contracts will likely be transitioned from LIBOR in two phases—one at the end of 2021 for non-USD LIBOR, and one phase in mid-2023 for USD LIBOR. Probably.

Regardless of the exact timing, the transition hinges on the International Swaps and Derivatives Association’s IBOR Fallback Supplement and Protocol. ISDA’s supplemented definitions, scheduled to be published on January 25, promote more robust fallbacks many in the industry are eager to incorporate. (The Murex team has outlined some elements of the transition extensively in a Risk.net article.)

In this evolving context, the right IBOR solution technology to address two major dynamics of the transition is necessary.

Practitioners must adapt their strategy to a timeline that remains fluid.

From a systems perspective, this means that practitioners must operationalize a seamless IBOR transition, regardless of exactly what happens.

The latest update was just the most recent example of something we already knew: the IBOR transition is going to be a long, phased process, spanning several years and including unknown and foreseen variables. The transition away from legacy LIBOR rates is going to be different across currencies, tenors, products and transitions. There will be “official” transition regimes. But there will also likely be bespoke, pre-agreed, bilateral transition regimes, and these will be different across various counterparties. Central counterparty clearing houses may themselves orchestrate some early transition regimes for cleared trades—some will “seek to go step further”.

If this sounds complicated, it is because it is complicated and will be complicated. To attempt to simplify: a transition regime must be understood as a new rate; a fixed spread to be added on top of the risk-free rate; and a transition date, along with other potential options around, say, management (or lack of management) of current periods or preservation of the initial commercial spread. 

Given all this, many sell-side institutions need to keep a clear record of the transition strategy for each counterpart, rate and instrument, and be ready to seamlessly execute it on the due date, without any risk of missing a trade, or executing the wrong transition regime on any trade.

MX.3 for IBOR Reform addresses these aspects. It keeps a record of all transition regimes across products, currencies and rates, including trade-level exceptions, if necessary. The solution also allows practitioners to define an effective date at which the transition can be automatically executed as part of the EOD procedure.

Another challenge is accounting for the transition in calculations and models pegged to announcement dates.

Examining this part of the problem requires differentiating between the two types of transitions: early or bilaterally agreed transitions, and official ISDA fallback protocol.

Counterparts that decide to perform the transition on a bilateral basis will do so in exchange for remuneration. In most cases, this compensation will be calculated and paid just before transition becomes effective. Until the transition date, therefore, a LIBOR instrument will continue being worth its LIBOR value using the full LIBOR curve, and hence be sensitive to the LIBOR curve only—as if it were not meant to be transitioned at all. The instrument must be valued on the RFR curve only when a compensation fee is fixed and paid (this will occur immediately before the transition date). In other words, for early/bilaterally agreed transitions, instruments can still be valued and risk managed as LIBOR instruments until the fee calculation date (i.e., the transition date).

In the second case, as per ISDA protocol, the transition happens without compensation—the rate simply changes on the official cessation/pre-cessation date, and that’s it. This means that the calculation of valuation and risks should account for this transition as soon as the announcement is made, possibly as early as February.

From the moment the announcement is made—the precise time the transition date and spread are known—LIBOR fixings beyond the official cessation date should be estimated as risk-free rate + spread, so that pricing, valuation and risk can be calculated accordingly.

MX.3 for IBOR Reform addresses this requirement by acting at curve level directly. When LIBOR cessation is announced, we will know with certainty what date it will disappear, so that any “LIBOR” estimation beyond this date becomes meaningless. The transition is easily and seamlessly accounted for—all fixings falling beyond the transition date are factored in. (Learn more about MX.3 for IBOR Reform in this Risk.net article.)

A “double-regime” curve makes it possible. It is based on two underlying curves: a traditional LIBOR curve until the transition date, and an RFR+spread curve beyond that date. Acting at the curve level enables fast and easy implementation across all products and business processes, with a very good level of accuracy.

Taking the right steps to smooth the IBOR transition is critical for our financial sector community. MX.3 for IBOR Reform should pave over bumps in the road.