The IBOR transition is now well under way on the derivative front, and some key steps have been taken in identifying various LIBOR replacements.1 The next challenge will be shaping the derivatives market for the new benchmark rates. Preliminary assessments have been undertaken to assess potential replacements for LIBOR derivatives.
Derivatives contracts referencing IBOR should contain robust fallback language, which unambiguously settles the transition. The International Swaps and Derivatives Association (ISDA) has suggested three different fallback compensation spreads – a forward approach, a historical mean/median approach, and a spot-spread approach – for inclusion in IBOR contracts.2 Over 150 responses to the ISDA consultation were received, from a large range of market participants around the world. At the end of 2018, The Brattle Group published a summary of them.3
Despite favouring the historical mean/median fallback, banks raised a number of concerns, such as the potential for a value transfer if a fallback is triggered. A key challenge is to maintain present value neutrality on the calibration date. Spot rates and forward rates are likely to be inconsistent. Average historical market conditions may not align with the market’s expectation for the future (e.g. change in monetary policy and economic conditions). Additionally, this approach requires long histories of fixings of IBOR and adjusted risk-free rates
Darell Duffie (Stanford GSB) recently suggested that compression auctions could help mitigate this risk, by allowing firms to convert their LIBOR exposures into new risk-free rate exposures prior to the discontinuation date, at a pre-determined cost. The idea behind a compression auction is to convert centrally-cleared contracts referencing IBOR to contracts referencing a different benchmark. The proposed algorithm contains two parts: an auction mechanism, which matches opposite positions to convert them, and a compression mechanism.4
The central clearing counterparty (CCP) running the auction would seek to minimize the post-compression gross total position for all firms (both IBOR and new risk-free linked contracts), subject to two constraints. First, it must maintain a net position of zero at each maturity. Second, it must reduce the gross notional position while satisfying the risk tolerances and compensation requirements of each firm. This second condition is to maintain approximately the same market exposure for each firm.
Participants first provide bids and offers. The auction mechanism then takes this input to determine the compensation rate. The compensation rate is to be paid by IBOR payers to IBOR receivers when converting their contracts to the new benchmark, as the benchmark rate is expected typically to be lower than the IBOR.
Additionally, participants can define risk tolerances for each maturity bucket. The algorithm then increases conversion by substituting positions of similar maturities. Setting narrow thresholds in the compression avoids any changes in P&L or maturity profile; however it limits the total amount of trades that can be ‘ripped up’. Playing with the widening acceptance thresholds in the trade compression would help reduce IBOR exposure at a ‘predetermined cost’, thus reducing the risks related to the IBOR discontinuation.
Figure 1 provides a simplified illustration of the possible result of a compression auction on a firm’s swap positions. Before entering the auction, the firm has legacy LIBOR-denominated swaps. In the auction, the firm’s positions are compressed and converted by the compression manager, under the participants’ bids, offers and risk tolerances, as well as the CCP’s constraints described previously. After the auction, the firm’s gross total position is reduced while keeping the net position unchanged. In addition, part of the legacy LIBOR-denominated swaps has been converted in this illustration to SARON-denominated ones.
While Duffie's working paper discusses centrally-cleared swaps, the concept can be extended to bilaterally-traded ones in the context of multi-party compression. Altogether, the approach allows market participants to weigh the risks of ‘being caught on the wrong foot’ on the transition date against a known P&L hit in a compression auction. If used well before the transition date, it could additionally provide a way to smooth the P&L impact over time.
From a practical perspective, it will not be possible to replace reference rates with new contracts immediately, and IBOR derivatives will still be traded over the coming years to hedge inherent interest rate risks. That said, firms should carefully monitor their IBOR exposure and start thinking about strategies to reduce the risks associated with a sudden IBOR discontinuation.
In the market, we observe that non-large broker dealers (e.g. asset managers) have started to move from a bilateral OTC set-up to central clearing, in order to benefit from CCP compression cycles, and thus mitigate the fixing risk at the time of the IBOR transition.
1 More details in our previous blog on (L)IBOR reform regulatory scrutiny – increasing the pressure
2 The benchmark fallbacks consultation – Compensation spreads and the ISDA consultation
3 The summary of responses to the ISDA consultation – Brattle Group’s summary of the responses
4 The full working paper by Darell Duffie – Compression Auctions With an Application to LIBOR-SOFR Swap Conversion