The Potential Wall at Cessation
Is this the way LIBOR ENDS?
As we approach the date when pre-cessation triggers become effective for GBP, JPY and CHF the transition for derivatives subject to the ISDA Fallback Protocol or Supplement may face the impact of hitting a wall where the reference rate changes suddenly.
This has been written about previously at Clarus and by the Murex team and in Risk.net. Then it was a theoretical problem about revaluations and curve construction; now it looks very real! And rather ironically, when this potential issue was first raised, the wall looked like a cliff where there may be a sudden fall in reference rates over the cessation date whereas now it looks more likely there will be a sudden increase in rates.
In this blog I look at the GBP and USD markets and how they are predicting the reference rate changes from LIBOR to the ISDA Fallback Rate on 31st December 2021 and 30th June 2023 respectively.
LIBOR is not necessarily Risk Free Rate plus Spread Adjustment (Fallback Rate)
The ISDA Fallback Rate is the Adjusted Reference Rate plus the Spread Adjustment for the relevant tenor of that period of the trade. Although this is commonly applied in derivatives there is some use in other products such as loans and securities.
The Fallback Rate replaces LIBOR after the cessation date or the effective date of the pre-cessation announcement, in this case after 31 December 2021 for GBP (and other non-USD LIBORs) and 30 June 2023 for remaining USD LIBORs.
Note that the Fallback Rate is a replacement and is not required to equal LIBOR. The LIBOR on the last day will behave as LIBOR always has and be subject to issues of liquidity and credit which may not equal the 5-year median in the ISDA Spread Adjustment.
GBP on 31 December 2021
The table on the right is where the markets are at this time and where they are predicting LIBOR and the Fallback Rate may be on 31 December 2021.
The yellow highlights show the potential difference in the reference rate applied to contracts. The current differences are around 3 bps (1-month), 9 bps (3-month) and 23 bps (6-month).
If we look forward to the market prediction on 31 December 2021, the the differences are smaller but still there, respectively approximately -1 bps (1-month), 6 bps (3-month) and 19 bps (6-month). This indicates contracts with a cessation date for GBP LIBOR on 31 December 2021 could see a jump in rate on 3 January 2022.
But a word of caution, the Fallback Rate is only known at the end of the relevant period and could differ substantially from the market predicted rate.
Note: the forward OIS and LIBOR rates for GBP and USD are derived from futures prices. In particular, the USD 1 and 3-month LIBOR rates may be too low dues to ‘turn of year’ effects.
USD on 30 June 2023
A similar outcome emerges in the USD LIBOR which is destined for effective cessation on 30 June 2023. Again the yellow highlights show the differences now on those predicted on 30 June 2023.
The 1-month difference is relatively minor however there are more substantial predicted differences in the 3 and 6-month tenors.
Potential impacts
Costs for borrowers and returns for investors
the sudden change in rate will give a potentially large difference between the reference rate on 31 December 2021 and 3 January 2022
small mismatches in reset dates between exposure and hedge may create large accrual differences
Modelling the gap
such a discontinuous change in rates is notoriously difficult to model
many systems will attempt to create a smooth curve around the dates which can impact revaluations on many days either side of the change (see the Murex article)
Differences in outcomes
LIBOR fixes at the start of the period while Fallback Rate has daily fixes during the period
the actual outcome may differ from the projected outcome at the start of the period leading to accrual differences
Summary
I end this blog very simply: LIBOR is not the ISDA Fallback Rate and it may evolve differently to the market expectations.
Changes to liquidity and credit spreads will impact LIBOR and the final outcome may not be consistent with the 5-year median approach in the ISDA Spread Adjustment and therefore the Fallback Rate.
So monitor the markets and be prepared for a potential surprise on cessation dates!
And finally a reminder of how much the Spread Adjustment can vary under extreme conditions. This is the GBP 3-month for the year up to June 2020 through the COVID-19 time.
The 5-year median is 0.1193% bit the spread went to approximately 0.80% before falling to its present level.
Source: Bloomberg