Why effective IBOR Transition starts with fallback methodologies

The markets that reference Interbank Offered Rates (IBORs) exceed $440 trillion in size, making the transition from IBORs to Alternative Reference Rates (ARRs) one of the biggest shake-ups to financial markets in recent history. Adding to the mammoth challenge of completing the IBOR transition by the end of 2021 is the current lack of robust and consistent fallback methodologies to prepare for the discontinuation of IBORs in existing contracts.

Several challenges remain to promote market consensus on fallback methodologies, both across products and among market participants. To start, there is some scope for divergence in approach between derivative products and cash products. This will likely have a material impact on firms’ transition strategy, as significant proportions of the derivative market exist to support the hedging of cash products.

Within derivative markets, the challenge to build consensus among market participants remains acute. An agreement on fallback methodology should not be under-estimated: not only does it form the premise to enact any changes to legal documentation, but it also enables the market to build momentum to drive effective IBOR transition.

To this end, ISDA, the trade association for derivative market participants, has issued a series of consultation papers and is currently consulting on the final parameters in relation to the Fallback Methodology. The finalised methodology will likely apply across all primary rates: as such, this will impact real P&L exchanged between counterparties, and is therefore key to commercial relationships as well as to conduct and litigation risks.

The building of market consensus will seek to minimise value transfer between ARRs and the old IBORs, which are not economically equivalent. The ARRs are structurally different as they are overnight rates rather than forward-looking term rates. This means legacy contracts will require adjustment to reflect the differences in both the term and credit risk premia.

Following prior consultations with market participants in 2018 and 2019, ISDA has proposed a methodology called “compounded setting in arrears rate with historical mean/median approach to spread adjustment”. With the current consultation concluding on 23 October, it is critical that a broad range of market participants respond to this consultation to ensure convergence of differing views.

This will require firms to focus on three themes:

The choice over historical mean or median averaging approach to the spread adjustment: The historical mean or median spot spread will be calculated and published for each relevant IBOR tenor based on historical differences between the IBOR for that tenor, and the corresponding RFR compounded over a time period with the same length as the tenor. As a result, the spread will differ across different tenors for the same IBOR. Bloomberg has already been selected as the Calculation agent once the methodology is finalised.

The length of lookback period (time for the averaging calculation): The impact of varying lookback periods can be significant. If the lookback periods span over the period of the credit crisis of 2008-09, the averaged spread will be less be representative of more normal market conditions, producing a larger adjustment.

Business day/holiday and settlement conventions (lag or lockout): As the new RFR rates are backward-looking, settlement conventions that allow for cashflow certainty will need to be included. Full details of business/holiday conventions also need to be locked down as they impact compounding interest calculations which apply to business days only.

From a conduct risk perspective, firms should be cognisant at all times that the objective of Fallbacks is to avoid mass-market disruption and the methodology selected should minimise value transfer. Hence, consultation feedback should be based on these principles, rather than P&L impact assessment in isolation.

The final methodology will have a real impact on P&L of legacy deals which reference IBORs as the spread adjustment dictates the value transfer and economic “winners and losers” of the transition itself. Time is of the essence and final decisions must be made, so legal drafting can be completed, ready for market uptake and implementation in early 2020.

Firms must factor all the above into their industry engagement strategy, transition planning and scenario-based impact analyses. To conduct these impact analyses and sufficiently inform strategy, firms must be able to generate a dashboard or suite of reports that connects exposures to documentation so they can fully understand the risks and make judgement calls with all the facts to hand.