LIBOR fallbacks….and the winner is…..5 year median

18 November 2019

Phil LloydHead of Market Structure & Regulatory Customer Engagement

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In what seems like an endless stream of consultations, the International Swaps and Derivatives Association (ISDA) finally give us clarity on the fallback mechanics - for derivatives at least, even though there's confusion as to what triggers this.

We're impressed how quickly the results on fallback rate mechanics have been announced since our recent note. The pace has certainly picked up and it needed to.  

ISDA only offered 2 options:

1) Median over 5 year from announcement

2) Trimmed mean over 10 years from announcement.

The Good... 

We now know the length of the look back period and averaging method - 5 year median 

... the Bad and the Ugly

We are still left scratching our heads over what will actually trigger this fallback. 

Are we waiting for enough banks to drop out such that the IBOR administrator announces they are unable to produce a rate?  

Or are we waiting for the regulator with their pre-cessation triggers and the contentious non-representativeness test. When is this called and what does that mean for markets, and yes, not just derivatives. See our Knock Out blow piece

When is this announcement date? If no pre-cessation triggers apply the fallback rate may only apply many years post 2022, all we know is it's after the end of 2021. In addition, there still seems to be some debate on the time between the announcement date and the cessation date - see diagram below

While we know many are going to be happy with 'The Good', many will still be holding breath for clarity around 'The Bad and The Ugly'.

So what next?

There will have to be more debate and clarity around pre-cessation triggers since one option from recent consultation was whether they get included within ISDA fallback protocol.

This protocol will be launched (maybe January?) and allow documentation to be updated with this fallback language for legacy transactions. Irrespective of protocol sign up, 3 months from protocol publication all new ISDA transactions will apply this fallback rate language.  

Beyond this other products and associations such as the Loan Market Association (LMA) have referenced ISDAs work so hopefully we will see progress in non-ISDA LIBOR space as well. 

The transition period was rejected (yes the diagram above is meant to have crosses out) and this was a surprise to us. Whilst we thought it might have been considerably shorter than the proposed year, as a mechanism to avoid a cliff edge change in spot basis on a particular date it seemed a sensible solution.

On another final note - upon initial reading, the ISDA backward-shift methodology seems to match the Alternative Reference Rates Committee (ARRC) recommended lookback method for Secured Overnight Financing Rate (SOFR) Floating Rate Notes (FRNs) for which the rate and weight is shifted by a number of business days. Sterling Overnight Index Average (SONIA) FRNs have used a slightly different method in which the rate is shifted, but weight remains the same as the coupon period. While this feels a clunky solution, from ISDA's perspective it's easier than investigating via yet another protocol amend the actual payment dates. The summary report acknowledges this may need further details to be determined by ISDA. 

So another step closer, some good, some bad and some ugly - still lots to play for.   

LIBOR


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