Libor reform: Spread, fallbacks and discounting changes

The ISDA IBOR protocol is imminent, and it is hugely important. A strong take-up is key for a successful transition away from Ibors. There are good reasons to sign up, as it provides an efficient means to incorporate Fallback provisions into numerous documents referencing Ibors, the result of wide-ranging consultations.

• These Fallback rates are not simply the new Risk Free Rates. They can’t be, as the economics surrounding the switch from Ibors to Fallbacks should be broadly neutral. So the Fallback rates are intended to represent the Ibors as best as possible. They are calculated as Risk Free Rates plus suitable spread adjustments.

• These spread adjustments will ultimately be fixed, coinciding with a pre-cessation statement that deems specific Ibors as unrepresentative at a certain point. Note that the spreads may be fixed well in advance of transition to Fallbacks, potentially spanning a number of months or a couple of quarters.

• The fixed spread adjustments will be useful information for all types of products that will be looking for a sensible spread with which to translate legacy Libor production to suitably replicate rates with minimal economic displacement. The early fixing of adjustment spreads may serve to facilitate this process.

• We find that Ibor fixings currently lie below Fallback rates to the tune of 10-15bp. These gaps are predicated to narrow going forward, but not by much. But a gap does not necessarily imply a net loss or gain; as that depends on the path of the Fallbacks. And even then, there are other nuances in play. We explain.

SOFR discounting - Auction action

SONIA secured a number of advantages by virtue of its reformed nature, and in particular the fact that it has been in use for a number of years. It has meant a quicker build in volumes, but also avoidance of a change in discounting rate. €STR went through its discounting change recently. SOFR is up next for centrally cleared trades.

• The discounting change to €STR (from EONIA) was simpler as there was a fixed basis of 8.5bp in play. On the switch from EFFR to SOFR the basis is typically lower than that, but the complication is that it varies by maturity, and over time.

• That said, there is a very smart auctioning system in place where players can make choices as to how they would like to deal with valuation shifts. Here a simple in and out strategy can work, or the position could be traded.

• Our preference is to take advantage of the liquidity available on transition through the auction system, to make the move as efficient as possible. Potential pain should be minimised. Trading it does not guarantee a better outcome.

• For many liability managers this will be a bit of a sideshow, bi-lateral contracts with banks on their derivatives portfolio dominate for corporates. But at the same time, this is an important stepping-stone in the direction of more SOFR use.