IBOR Transition: Fallback provisions and spread adjustments - Banking blog

IBOR Transition  Fallback provisions and spread adjustments

The transition from interbank offered rates (IBORs) to new alternative risk-free rates (RFRs) marks a historic turning point in financial markets. With cessation of LIBOR expected for the end of 2021, banks and other financial players need to focus on suitable transition planning. Swiss banks have already gained some experience in this regard, with the transition from the Tomorrow/Next Indexed Swaps (TOIS) fixing to the Swiss Average Rate Overnight (SARON); but the replacement of CHF LIBOR will be far more complex due to its importance as the basis for pricing Swiss loans. A large proportion of financial contracts referencing CHF LIBOR has maturity dates beyond 2021, so fallback provisions need to be high on the transition agenda  of Swiss banks, to ensure contract continuity.

The fallback framework developed by the International Swaps and Derivatives Association (ISDA), widely adopted by national working groups, has three component elements. The fallback description, including pre-cessation and cessation triggers, needs to be defined; and both term rate and spread adjustments need to be made, as a consequence of structural differences between IBORs and RFRs. While the focus of this blog is on spread adjustments for CHF LIBOR and SARON, the concepts described here can be applied generally to  other currencies such as the US dollar.

Differences between CHF LIBOR and SARON requiring spread adjustments

SARON is a risk-free, collateralized rate derived from overnight transactions in the secured Swiss money market; and it therefore differs substantially from CHF LIBOR, which is an unsecured interbank lending rate. CHF LIBOR incorporates not only a credit risk premium, but also an additional term premium reflecting liquidity and fluctuations in demand and supply.

Structural difference CHF LIBOR and SARON

Figure 1: Structural differences between CHF LIBOR and SARON leading to spread adjustments (Source: Deloitte, 2019)

As illustrated in Figure 1, spread adjustments need to be introduced to account for the differences between SARON and CHF LIBOR, ensure contract continuity and minimize value transfer on transition. While developing the fallback framework, the following three guiding principles have been followed by  ISDA and other working groups:

  • Minimizing value transfer when the fallback is applied;
  • Eliminating any potential for manipulation;
  • Mitigating market disruptions when fallback is triggered.

The following three spread adjustment approaches have been the subject of extensive ISDA consultations:

  • Forward approach: Calculation based on observed market prices for the forward spread between CHF LIBOR and SARON at the time of the trigger;
  • Historical mean or median approach: Based on the mean or median difference in spot between CHF LIBOR and SARON, calculated over a fixed lookback period;
  • Spot-spread approach: Based on the spread between the CHF LIBOR and SARON spot rates on the day preceding the announcement or the event triggering the fallback.

Characteristics of spread adjustment methodologies and market consensus

All three spread adjustment approaches outlined above have advantages and disadvantages, as shown below.

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Figure 2: Advantages and disadvantages of the main spread adjustment methodologies (Source: Deloitte, 2019)

As all three methods fulfil the selection criteria to different degrees, there is no single option tailored to all needs that guarantees zero value transfer (i.e. there will always be a transfer of economic value between the parties involved in the financial contract). Nevertheless, the choice of approach to specific spread adjustment must ensure a smooth transition and consistent methodology.  Following ISDA consultations in which the majority (almost 70 per cent) of market participants indicated their preference for it, the historical mean/median approach was selected based on its simplicity, robustness, and resistance to distortion and manipulation. Further refinement and detailing of the historical mean/median is expected to be finalized by the end of 2019, when the type of average (mean, trimmed mean or median) and the length of the lookback period need to be specified.

Swiss perspective on fallback design

The Swiss national working group (NWG) on reference rates has focused on an appropriate fallback design, spread adjustments. For derivatives, the suggested fallback procedure is to amend the ISDA protocol and master agreements in accordance with preferred historical mean/median methodology. Initial NWG analysis (presented at its 21st meeting) indicates that the median is more stable than the mean, when comparing 6M - CHF LIBOR to a calculated 6 month compounded in arrears SARON. As a result, the median should be the preferred approach for minimizing value transfer.

For loans and deposits. the NWG developed a dedicated fallback template along with law firm Homburger. The necessity for the development of a Swiss specific template is due to the fact that international model clauses have been developed for professional counterparties, while CHF LIBOR is also used widely in the retail mortgage lending market in Switzerland. Within the proposed framework, the following waterfall approach is suggested to determine suitable LIBOR replacement rates for loans and deposits:  

  • The most equivalent reference rate calculated and quoted by a third party (e.g. Bloomberg) is used;
  • The third party specifies an add-on to account for the gap to the new reference rate;
  • The bank applies an addition or deduction to determine the new interest rate; the new rate is specified with reference to historical CHF LIBOR rates.  

Recommendations and conclusion

With fallback provisions to be finalized by ISDA by the end of this year, Swiss banks need to start intensifying their transition efforts and developing targeted solutions. We strongly recommend getting started on a suitable transition strategy for affected products and contracts. Proactive, transparent client communication will be key, along with a LIBOR portfolio strategy and contractual remediation design.

Swiss banks need to prepare for the fallback provisions (including pre-cessation triggers) becoming effective when LIBOR cessation is triggered. As already pointed out in previous blogs, implementation of the transitional changes will be a massive undertaking, impacting downstream systems, processes and procedures across the bank. With the forthcoming definition of fallback provisions, Swiss banks need to observe developments closely and  align their approach with the decision process in the market. Once the fallback design has been specified, calculation engines and systems need to be adjusted, based on the ISDA requirements and the proposed template for retail loans.

For more about the transition process, explore Deloitte’s recently published insights on the journey ahead for IBOR.

Sergio Cruz

Sergio Cruz - Partner, Consulting

Sergio is a Partner at Deloitte’s Operational Transformation banking practice with strong expertise in risk and regulatory driven transformation.
Sergio has over 22 years of experience in financial services with a focus on banking operations, where he worked on several large assignments both in Switzerland and abroad, covering the implementation of regulatory requirements, the definition and implementation of target operating models and the development of front-to-back processes. Examples of areas Sergio covers include IBOR transition, FIDLEG / LSFin, FATCA / AEI, Basel requirements as well as cross-border investigations.

Key clients Sergio has worked with include Swiss global and private banks as well as major UK and US banks.

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Dominik Ouschan

Dominik Ouschan - Senior Manager, Financial Services

Dominik is a Senior Manager in Deloitte’s Financial Services Strategy & Operations Consulting team in Zurich and has more than 5 years of experience in consulting. He leads Deloitte Switzerland’s Regulatory Transformations offering and specializes in the effectiveness & efficiency as well as future of the Compliance function. Dominik is the co-author of the Deloitte point of view “Compliance 2025: DNA evolution in the Financial Services Industry”.

With close to 10 years of experience in the banking sector, he has served clients in the private banking, asset management and wealth management industry, primarily in their Corporate Center functions.

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