Last month I wrote a blog that described the ‘Dear CEO’ letters sent to many financial firms from regulators in UK, EU, Switzerland, Australia and Hong Kong. Also the US FED has added a Libor component to their regular supervisory requirements to assess the transition from Libor to other benchmarks for firms they supervise.
In most cases, regulators are directly requiring firms to show significant progress to new benchmarks, typically Risk Free Rates (RFRs) such as SOFR and SONIA. This is generally focussed on the internal risks for the firms and how this may impact their books and prudential management.
But many regulators such as FCA (Point 7 in their letter) and ASIC (Paragraph 5) have also emphasised the customer impacts.
Firms are required to give consideration to ‘fair outcomes’ for their customers: this may be complex in a transition from Libor to RFRs. The concept of ‘fair’ is not an exact science and can be challenged in the future if markets move adversely for the customer.
Potential customer impacts
Customers can be impacted in several ways that have the potential for positive or negative outcomes for a transition from Libor (or any other benchmark) to another benchmark. Among the customer options for transition are:
- No change to the current fallbacks (do nothing);
- Replacing current fallbacks with new fallbacks (to accommodate a cessation event); or
- Changing the benchmark from Libor to a new benchmark (move before a cessation event).
Each of these options has pros and cons: these will have to be explained clearly to the customer before making any changes to existing contracts.
The challenge for firms is finding an independent and reliable way to value the alternatives such as those above and present the scenarios that could impact the valuations in the event of a benchmark cessation.
Changes to derivative contracts
ISDA published the summarised results of their consultation for fallbacks for GBP, AUD, CHF and JPY in December 2018.
Since then, ISDA has also published preliminary consultation results for pre-cessation triggers as well as USD, CAD and HKD fallbacks.
In the case of fallbacks, the consensus is to adopt the RFR (compounded, settled in arrears) plus a credit/liquidity spread. ISDA have just appointed the calculation agent (Bloomberg) for the spread calculation. But some parameters for the calculation have yet to be settled (i.e. the time period for the average and whether to use the the mean or median).
In previous blogs, we have commented on the possible spread calculation outcomes for GBP and AUD. In some cases, the spot spread can be quite different to the long-term average and would therefore have a significant impact on valuations.
The ISDA consultations resolved to use the spot spread and have this amortise to the average over a period of 1 year. It is this issue that can result in valuation changes over the life of the derivative until the spot (and average) spread is set on Libor cessation.
It is this volatility of the spread and its potential impact that needs to be made clear to customers at the time of changing a derivative contract to incorporate new fallbacks. The spread at the time of the cessation trigger will have a considerable impact on the customer and needs to be explained.
The spread will need to be added to the compounded RFR (see Clarus Products – Term RFR) for each currency. At this stage, the spread and average are not known until published by Bloomberg, however we can make plausible estimates of the likely value and bounds of this spread.
The current valuation changes will need to be clearly disclosed for each option above as well as the potential scenarios that may impact future valuations.
And all this will need to be independent and well documented by firms!
Changes to derivative contracts – the options
The three options above will all have implications for customers:
1. Do nothing and accept the current fallbacks
This is not really an option as in many cases such as Libor, the fallbacks are unlikely to be available. For example, where the calculation agent is required to find 3 or 4 quotes from market participants, after Libor ceases to exist it will be highly problematic to find 3 – 4 willing participants!
The contract may then be considered ‘frustrated’ with serious implications for both the customer and the firm involved.
2. Replacing current fallbacks with new fallbacks
Another option is to use the new fallback language when it is available (e.g. included in the ISDA 2006 Definitions) and apply this to the existing contract(s).
Although this appears to be an easy option to allow for a better fallback while still using Libor until it ceases, problems can arise with valuations before the cessation event and managing the rates fixes after the event.
The valuation difference at the time of the contract changes may not be the valuation difference when the cessation event occurs (based on the changes to the spread mentioned in the previous section).
3. Changing the benchmark from Libor to a new benchmark
This option has the advantage that the clarity of the valuation difference at the time of renegotiation is known and will not change – effectively it is a basis trade that is fixed at that time.
New benchmarks could be compounded, in arrears settled RFRs or Term RFRs when available.
The three options have different pros and cons that will need to be disclosed to the customer at the time of renegotiation along with the valuations and potential scenarios that could impact the future valuation.
Mitigating the risks of ‘unfair’ customer outcomes
Since most firms will be the only counterparty with the exact deal to be renegotiated, it may be difficult or impossible for the customer to get a comparison valuation or rate. Of course, in a syndicated deal a number of firms will have the same structure booked with the customer (perhaps with different nationals) but this will likely be rare.
How does the firm and their customer gain comfort that the valuations and options for renegotiation are ‘fair’?
The answer is an independent valuation of the options from a reliable source.
Clarus Apps and Microservices
Clarus offers Web Apps and Microservices API for impact analysis of the IBOR transition. These can be used quickly and efficiently to price a customer trade or portfolio in an independent system, which is generally the requirement of jurisdictions to show transparency and a fair outcome for the customer. Functionality includes:
- Calculate an estimated value for the fallback with high and low bounds
- Use your own estimates or the actual fallback when published
- Value trades or portfolios to determine changes in market to market
- Understand how risk transforms from Libor to RFRs
All available in a Web App or in Excel spreadsheets; making it easy for end-users working on impact analysis to understand and explain the choices to customers. And, of course, maintaining records of the scenarios and decisions will be important to reduce risk for your firm and the customer.
There is clearly an imperative to change trades to avoid significant disruption after 2021 and Clarus tools can play a crucial role in ensuring an independent valuation is provided to the customer.
The ‘Dear CEO’ letters place considerable emphasis on fair outcomes for customers during the contract renegotiations before 2022 when Libor is expected to cease being used commonly in contracts.
Clarus Apps and Microservices APIs provide a fast, efficient and cost effective way to create independent valuations for customers under different options for a post-Libor world.