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ISDA consultation on certain aspects of fallbacks for derivatives

October 20, 2018


Chatham's response to ISDA's consultations on amending the 2006 ISDA Definitions to provide fallback definitions for key IBORs upon their permanent discontinuation.

Consultation on certain aspects of fallbacks for derivatives referencing GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR, and BBSW

Executive summary

Chatham believes that the key criterion for determining an appropriate fallback is the minimization of value transfer. Chatham also believes that the appropriate fallback approach in normally operating markets will incorporate a Compound Setting in Arrears Rate and a spread adjustment using the Forward Approach. In markets that are not operating normally, we believe that the appropriate approach will incorporate a Compound Setting in Arrears Rate and a spread adjustment using the Historical Mean/Median Approach.

Chatham believes that sourcing the necessary data for the long end of the curve may prove challenging, as the market becomes very thin. Additionally, there are key pricing differences between different clearing houses and the over-the-counter markets that may also prove challenging as the fallback is implemented. Once a fallback approach is selected, Chatham recommends that ISDA should initiate another consultation to vet more specific implementation issues.

Finally, Chatham would implore ISDA and other market participants, like the Alternative Reference Rates Committee (ARRC) and the Financial Accounting Standards Board (FASB), to standardize approaches to the IBOR fallback in order to minimize the potential for market disruption.

A detailed discussion of these items is included in Chatham's response.

Overview of Chatham’s preferred approach

After analyzing the data, Chatham does not have a universal fallback preference. Accordingly, Chatham proposes two ranking systems to reflect Chatham’s IBOR fallback preference.

Ranking System 1: Normal Market Conditions. As discussed further below, Chatham’s first ranking system evaluated fallback methodologies for IBORs operating under normal market conditions. Chatham considers a normal market condition to exist when there is a positive spread between the applicable IBOR and its accompanying risk-free rate. Chatham has used Ranking System 1 to determine the fallback methodology for GBP LIBOR, JPY LIBOR, TIBOR, and Euroyen TIBOR.

Ranking System 2: Anomalous Market Conditions. Non-standard or anomalous market conditions exist in multiple forms. For example, there may be low market liquidity and a negative credit spread between the applicable IBOR and its risk-free rate alternative. As shown in the Bloomberg graphs provided by ISDA (see Figure 1), the CHF forward credit spreads are sometimes negative with regards to the Forward Approach. Chatham expects this negative spread to be merely a temporary condition and therefore excludes the Forward Approach when considering the CHF LIBOR fallback. While Chatham considers the market conditions for CHF LIBOR to be temporary in nature, because these conditions inform how the market is currently functioning, Chatham believes that a separate set of evaluation methodologies should be applied for CHF LIBOR. Accordingly, Chatham is using Ranking System 2 for the evaluation of a fallback for derivatives referencing CHF LIBOR.

Additionally, there may be a difference in the regulatory and administrative set up for a benchmark interest rate. In the past two years, BBSW has been extensively reformed. It is expected that BBSW and the RBA cash rate will coexist for some time as key benchmarks in Australia. Any forward-looking calibration could be well out of date by the time a fallback is initiated, if a fallback is initiated in its current form at all. Chatham also uses Ranking System 2 for the evaluation of derivatives referencing BBSW.

1.1 Criteria for Evaluating Term Fixings and Spread Adjustments

As discussed further below, Chatham has excluded both the Spot Overnight Rate and Convexity-adjusted Overnight term fixing methodologies and the Spot-Spread Approach credit spread methodology. Therefore, Chatham considered whether compounding should be in advance or in arrears for the term fixing methodology and compared the Forward Approach to the Historical Mean/Median Approaches for spread adjustments. The following weighting schemes were used to evaluate the term fixing and credit spread criteria.

1.1.1 Weighting Scheme for Term Fixing Methodologies

When analyzing the term fixing methodologies for the Compounded Setting in Arrears Rate and Compounded Setting in Advance Rate, Chatham considered the following four factors: volatility, how closely the methodology mirrors IBOR, predictability of rate (i.e., known in advance), and simplicity. The table below identifies how Chatham prioritized these four factors, with a “High” rating constituting a more significant weighting.

Chatham four factors prioritizing term fixings

Chatham's four factors in prioritizing term fixing methodologies

1.1.2 Weighting Scheme for Credit Spread Adjustment Methodologies

When analyzing the spread adjustment methodologies under consideration, Chatham employed the below weighting methodology. Specifically, Chatham has included a conditional requirement that markets are available and the ability to manipulate markets is low. Only spread adjustment methodologies that satisfy both conditions were subsequently assessed using two factors: 1) value transfer and 2) data requirements. Spread adjustment methodologies that could not satisfy both conditions were excluded from our response.

Chatham's weighting scheme for credit spreads

Chatham's weighting scheme for credit spread methodologies

1.2 Ranking system 1

Ranking System 1 should be considered for derivatives referencing GBP LIBOR, JPY LIBOR, TIBOR, and Euroyen TIBOR. In general, Chatham recommends this ranking system under normal market conditions. Chatham caveats that Ranking System 1 will not be representative if both the IBOR and risk-free rate markets are non-liquid at the same time. Additionally, it is imperative that ISDA develop an approach to generate forward curves by choosing the calibration instruments and model that is fair to market participants.

1.2.1 Ranking

For GBP LIBOR, JPY LIBOR, TIBOR, and Euroyen TIBOR, Chatham ranks the methods in order of preference as follows:

Chatham's order of preference for credit spreads

Chatham's order of preference for credit spread methodologies

Chatham's ranking system for credit spreads

Chatham's ranking system for credit spread methodologies

1.2.2 Explanation

Regarding the term fixing methodology, Chatham favors the Compound Setting in Arrears Rate over the Compound Setting in Advance Rate. In arriving at this conclusion, Chatham notes several things. First the Compound Setting in Arrears Rate covers the same interest period as the relevant IBOR. Conversely, the Compound Setting in Advance Rate covers an earlier period. Therefore, the Compounded Setting in Arrears Rate can capture the expected rates hikes in the same way the relevant IBOR currently does. The Compound Setting in Arrears Rate approach does give rise to operational hurdles; however, we believe these to be surmountable.

Regarding the spread adjustment methodologies, Chatham believes that the most important goal of the IBOR transition process is to minimize value transfer. By construction, the Forward Approach can make the present value of the derivative with the fallback close to the value of the derivative with the relevant IBOR. Therefore, the Forward Approach is preferred over the Historical Mean/Median Approach. As a result, the Forward Approach with either compound term fixing methodology are ranked first and second followed by the Historical Mean/Median Approach with either compound term fixing methodology, which are ranked third and fourth.

In Ranking System 1, the Forward Approach is favored because of its ability to minimize value transfer. However, it should be noted that he Forward Approach in practice will still have some value transfer for at least three reasons. First, there can be a time delay between the calibration of the Forward Approach and its activation. In this intermediate period, it is possible for markets to shift significantly which will not be captured by the Forward Approach. For IBORs, which may end by 2021, the intermediate period is likely to be less than two years. For the Australian market, a trigger may not occur for an extended period of time. Second, the forward curves used in the fallback may differ from the forward curves already being used by market participants to value derivatives. This difference will lead to value transfer for market participants whose valuations are based on forward curves that either use different market instruments for calibration or different models to generate the curves. Third, the Forward Approach allows for averaging over calibration dates to smooth out any daily fluctuations. Any averaging will potentially introduce differences between the current expectations of future rates and the historic averaged expectation of future rates. Given some averaging in the calibration process, it is likely that there will be some value transfer. Despite these challenges, Chatham ranks the Forward Approach above the Historical Mean/Median Approach.

1.3 Ranking system 2

Ranking System 2 should be considered specifically for derivatives referencing IBORs with anomalous market conditions, namely CHF LIBOR and AUD BBSW.

1.3.1 Ranking

When markets are not functioning normally, Chatham created Ranking System 2 which excludes the Forward Approach and uses only the Historical Mean/Median Approach. For CHF LIBOR and BBSW, Chatham ranks the methods as follows:

Chatham's order of preference for credit spread methodologies for derivatives referencing IBORs with anomalous market conditions

Chatham's order of preference for credit spread methodologies for derivatives referencing IBORs with anomalous market conditions

Chatham's ranking system for credit spread methodologies for derivatives referencing IBORs with anomalous market conditions

Chatham's ranking system for credit spread methodologies for derivatives referencing IBORs with anomalous market conditions

1.3.2 Explanation

With respect to Ranking System 1, Chatham assumed markets are functioning properly, market participants are behaving in good faith and the time between any model calibration and fallback application was not too long. In practice, these assumptions can fail. A ranking system that prioritizes the minimization of expected value transfer should be conditional on the ability to easily implement the method, ability to guard against manipulation and a relatively short time lag between model calibration and fallback trigger.

There are several ways markets can be in unusual states. For example, at the time of calibration, markets may be in a rate environment where the credit spreads are temporarily negative. This appears to be the case for CHF LIBOR as shown in Figure 1.

Additionally, one or more of the interest rate markets may no longer be liquid enough to provide reliable prices. This would especially impact the Forward Approach. As an example, when the risk-free rate derivative markets are maturing, the LIBOR based derivatives markets will have already dried up in anticipation of the fallback trigger. The current YTD statistics that ISDA has gathered, summarized in the table below, show the current lack of depth in the CHF/SARON derivatives market. At this point a holder of a portfolio of derivatives could also try to influence the forward rates by being a buyer or seller of new contracts that would positively affect their portfolio value.

Comparative lack of depth in the CHF/SARON derivatives market

Comparative lack of depth in the CHF/SARON derivatives market

The Forward Approach is also more sensitive to the timing of market variations, such as, intra-month seasonality of rates. If financial markets are experiencing a temporary market anomaly, prices will change in a volatile way. An example of this is a financial crisis. Chatham’s viewpoint is that the negative forward credit spreads for CHF, see Figure 1, represent a temporary market anomaly.

CHF 1-M Forward Rates and Spreads

Figure 1: Bloomberg’s Forward Credit Spread for 1-month CHF Rates

Although forward spreads may become positive when the fallback is calibrated, and rates in Switzerland are expected to rise, given both the history of negative forward credit spreads and more importantly, the current lack of market liquidity in SARON, for CHF LIBOR Chatham excludes the forward credit spread approach.

Finally, the utility of the Forward Approach is that it can help minimize the value transfer on the trigger date if the trigger date is relatively close to the calibration date. Therefore, the Forward Approach can be well suited for IBORs where administrators and regulators are making clear that the applicable IBOR is very likely to be discontinued in the next few years.

However, Australia is in a different situation. The general sentiment seems to be that BBSW has been reformed over the past two years, so it is likely that both BBSW and RBA will coexist as fully functioning benchmark interest rates for many years. Both rates have derivative markets that are of reasonable size and serve different parts of the market. For BBSW, the fallback amendment will make the ISDA contract more robust in case of a discontinuation, and the fallback will not likely be used for some time, or it may never be used.

This long potential time lag before a trigger means that market conditions will likely change before a fallback is triggered. The Forward Approach is not well suited for minimizing value transfer if the trigger is well in the future of the time of calibration because it will not reflect changes to the market since the calibration. We exclude the forward credit spread approach because its main use case, namely the minimization of value transfer on the trigger date, does not apply.

1.4 Excluded approaches and rates

In addition to the exclusion of the Forward Approach with regards to the fallback for CHF LIBOR and BBSW, Chatham broadly excluded three of ISDA’s proposed methodologies for all IBOR fallbacks for derivatives referencing GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, and Euroyen TIBOR as described further below. For the term fixings, Chatham has excluded the Spot Overnight Rate and the Convexity-Adjusted Overnight Rate. For the credit spread adjustments, Chatham has excluded the Spot-Spread Approach.

1.4.1 Excluded risk-free rate term fixing methodology: spot overnight rate and convexity-adjusted overnight rate approaches

Chatham excluded both the Spot Overnight Rate and Convexity-Adjusted Overnight Rate as term fixing adjustments from consideration in this ranking for two primary reasons.

First, one of ISDA’s stated primary considerations for selecting a risk-free rate adjustment approach is to minimize disruption. If ISDA selects a spot term structure, such a term structure will be qualitatively different from the relevant IBOR in several ways. For example, spot is more volatile than a term-IBOR and, in certain cases can have intra-monthly seasonality as shown in Figure 2.

RFR differences in bps versus day of the month

Figure 2: Example of Relative Risk-Free Rate Differences in bps versus Day of Month

Additionally, because a spot-based adjustment methodology is not forward looking, the adjusted term structure will jump discontinuously whenever interest rates are raised or lowered. In contrast, the relevant IBOR term structure will typically anticipate and smoothly transition to a new level before an expected rate change because the IBOR term structure incorporates anticipated rate hikes and declines into its forward curves. The time lag between IBOR’s anticipated ion of a rate hike and the actual hike will usually take approximately one to two months to be reflected. This time lag will be especially noticeable whenever a financial market is in a rising or falling interest rate environment.

The second reason Chatham is opposed to both the Spot Overnight Rate and Convexity-adjusted Overnight Rate is their unusual convention. The spot term structures do not mirror that of other OIS derivatives. From Chatham’s perspective, the IBOR transition has the potential to create significant market disruption and ISDA should try to minimize this potential disruption wherever possible. Because other standard market conventions already exist, it makes more sense to employ a pre-existing market convention rather than establishing a new market convention.

It should be noted that while Chatham has excluded Spot Overnight Rate and Convexity-adjusted Overnight Rate from its response, spot methodologies handle unexpected changes in interest rates better than the other proposed methods. While this is a valuable feature of the spot rate, Chatham would respond that markets are normally not in a state of continual crisis where shifts in interest rates are not signaled ahead of time. Therefore, it is not recommended to use either the Spot Overnight Rate or the Convexity-adjusted Overnight Rate due to the disqualifying reasons identified above.

1.4.2 Excluded spread adjustment methodology: spot-spread approach

Chatham’s viewpoint is that when possible, it is useful to eliminate methods that, from Chatham’s perspective, either are inferior to other remaining methods or that are, in general, not as promising. Of the three spread adjustments presented in the ISDA consultation, Chatham is completely opposed to the Spot-Spread Approach for two reasons.

The first reason is that the Spot-Spread Approach is not a distinct option. As defined, the Historic Mean/Median Approach starts off as the Spot-Spread Approach and gradually transitions to a historic looking spread. In the case when the historic looking spread is chosen to be spot, then the Historic Mean/Median Approach is the Spot-Spread Approach. While this is certainly an edge case of the Historic Mean/Median Approach, it also demonstrates its flexibility. This flexibility of the Historic Mean/Median Approach allows for improvements over the spot credit spread.

In addition, the Historic Mean/Median Approach is better than a pure spot method because the Spot-Spread Approach is very sensitive to the calibration date. As shown later in Figure 2, risk-free rates can have intra-month variability of several basis points over the course of a given month. If ISDA selects the Spot-Spread Approach, there is the potential for significant value transfer solely because of the selection of an arbitrary calibration date. This arbitrary spread will then persist into the future unlike the Historic approach which will revert to a historic long-term average. Assuming enough historic data is available, the Spot-Spread Method should be eliminated as a choice.


2.1 Comments on adjusted risk-free fate methodologies

Chatham represents end-users in the derivatives market and took into consideration the operational challenges for end-users regarding each risk-free rate methodology.

2.1.1 Compounded setting in arrears rate

The Compounded Setting in Arrears Rate is attractive to end-users because it is forward looking and reflects the actual rate conditions of the period. Rate movement during the Calculation Period is appropriately reflected in the cash flows that follow by incorporating the Forward Approach allowing market changes to be reflected in the final rate.

The main disadvantage of Compounded Setting in Arrears Rate from an operational perspective is that the relevant rate would not be known to derivative end-users until the end of each Calculation Period. This challenge alone represents a dramatic change for end-users whose internal finance programs, accounting processes, and treasury departments are structured around knowing the relevant rate at the beginning of each Calculation Period. Often, treasury departments require approvals prior to making payments. This operational requirement can take several days and relies on the relevant rate being known before the Calculation Period End Dates to make timely payment. While this challenge could be mitigated by incorporating payment delays into contracts, the shift to setting the rate at the end of the Calculation Period requires significant changes to these internal processes and decision-making frameworks.

Additionally, without having the rate in advance, treasurers may be uncomfortable making financing decisions. For example, corporate treasurers often draw down a short-term revolving line of credit for short-dated financing needs. If the treasury group is uncertain regarding how much they will need to draw upon its revolving line of credit, for fear of either drawing down too much or too little, it could lead to increased administrative burden and potentially additional interest costs for corporate treasury groups.

2.1.2 Compounded setting in advance rate

Operationally, the Compounded Setting in Advance Rate allows for end-users to keep their existing treasury processes and internal requirements consistent with current operations. By keeping the relevant rate setting in advance of the Calculation Period, end-users could focus on the other inevitably burdensome operational challenges with the IBOR transition

Another benefit for end-users of the Compounded Setting in Advance Rate is that the published benchmark can be referenced, looked up, and reproduced quickly and easily throughout the period.

The disadvantage of Compound Setting in Advance is that it is backward looking, and thus doesn't reflect market-anticipated rate movement. This short-coming could result in market participants attempting to manipulate the market in their favor if they have a view or expectation of where rates will go. For example, if the market anticipates a rate hike during an upcoming period, a borrower would be incented to draw more money on a revolving credit facility at the previous lower rate because the increase in interest rates would not be reflected until the next reset date. A forward-looking methodology will eliminate these concerns because the anticipated rate hike already will be incorporated into the rate.

2.2 Comments on spread calculation methodologies

End-users would possibly be indifferent between the Forward Approach and Historical Mean/Median Approach from an operational perspective. Both approaches share many of the same pros and cons. Internally, for end-users, the complexity of both the Forward Approach and Historical Mean/Median Approach compared to the Spot-Spread Approach would be difficult to communicate and understand because of the simplicity associated with the Spot-Spread Approach relative to the more calculation intensive Forward and Historical Mean/Median Approaches. However, since both the Forward Approach and Historical Mean/Median Approach are bound to be far more reflective of actual market spreads between the relevant IBOR and the fallback, these approaches take precedence over the Spot-Spread Approach.

2.2.1 Forward approach

Should the forward approach be based on data from the day prior to the trigger only or a number of days or months prior to the trigger? If the latter, how many days or months?

Chatham’s approach considers three time scales: 1) the intra-month seasonality, 2) the time for markets to change, and 3) the daily fluctuations. The first is the intra-month seasonality as shown in Figure 2. This seasonal change in the RFR rate can have a substantial impact on the start of the forward curve depending on the day of the month the forward curve is calibrated. As shown in Figure 2, the beginning and end of month periods for SONIA (and for TONA) typically have lower rates. However, there is a substantial part of the middle of the month, where rates are usually stable. To avoid the intra-month seasonality, Chatham maintains that either the calibration date should be chosen to be in the middle of the month or that the forward approach should use more than a month of data to avoid this intra-month pattern.

However averaging leads to another issue which is that market changes since the beginning of the averaging period will not be fully captured and can be substantially larger than the smaller daily fluctuations. Of the options to be explicitly considered, Chatham believes that the one and three-month options are not tenable. Shorter averaging periods of five days typically lead to changes of a few basis points. As long as the forward approach is calibrated on a day away from the beginning and end of the month, then using data from five days prior to the trigger will lead to the smallest valuation changes.

What is the appropriate length of the forward spread curve?

The forward spread would ideally extend out to 60 years so that long dated derivatives would be fairly valued. However, Chatham recommends trying to calibrate a 30 year forward credit spread and keeping the spread constant after that. Trying to calibrate a curve beyond 30 years can problematic because of lack of market data. Also, the lack of market liquidity would make the spreads a target for manipulation.

Would it be acceptable to use data for cleared transactions only when using the forward approach to calculate the spread adjustment?

Chatham recommends using only cleared transactions as they represent a significant majority of the traded notional within the interest rate derivatives market. ISDA’s current YTD statistics show that of the $169 trillion traded interest rate notional, about $149 trillion or 85% have been cleared. In comparison, about 89% of interest rate derivatives were cleared in 2017. Non-cleared trades lack the market uniformity and transparency of cleared derivatives.

Differences between the CCPs have traditionally been small but grown much bigger over the past few years. These differences are related to factors such as different margining requirements and who the market participants are. While these differences may shrink over time, for now Chatham recommends using transactions from both CCPs and adjusting for the differences such as margining requirements.

2.2.2 Historical mean/median approach

What is the appropriate historical static lookback period?

The Historic Mean/Median Approach aims to capture the cyclical nature of markets and, over time, revert to the mean. Therefore, it is important to understand the relevant time scales for the market to complete a cycle.

After the recent financial crisis, it took upwards of five years for markets to stabilize. However, even today many markets remain in an unusual position of low interest rates. While a ten-year lookback would be attractive due to its inclusivity of different market regimes, Chatham believes this would give too much weight to the crisis relative to the rest of the ten-year lookback period, for example see the credit spreads in Figure 3. If more historical data were available, it is likely the lookback would result in a more stable and accurate credit spread. Given the limitations of the historic data, however, Chatham recommends the use of the five-year lookback period which better captures the weighting of events and excludes the 2008 Financial Crisis in the historic lookback period.

Fig 3 credit spread of 3M IBORS

Figure 3: Credit Spread of 3m GBP LIBOR, CHF LIBOR, JPY LIBOR, BBSW

Should the calculation be based on the mean or the median spot spread between the IBOR and the adjusted risk-free rate?

To evaluate the use of either the mean or median spot spread between the IBOR and the adjusted risk-free rate, Chatham presents Figures 4 and 5 as summary statistics from our analysis. The data for Chatham’s analysis is calculated as of January 1, 2016.

Fig 4 3M spread using compound arrears

Figure 4: Comparison of 5-year mean and median and 10-year mean and median compounded in arrears

Fig 5 3m spread using compound advance

Figure 5: Comparison of 5-year mean and median and 10-year mean and median compounded in advance

Chatham recommends using the historic median. In our historic scenario analysis, the median historic credit spread resulted in fallbacks that were more similar to the IBOR it replaced across currencies and different historic averaging lengths.

In our scenario testing, Chatham envisioned that the fallback was triggered historically (January 1, 2016). Chatham calculated the mean and median credit spreads between the 3m IBOR and the compounded term rates up to the scenario’s fallback trigger. Chatham then calculated the fallbacks going forward and compared it to the relevant IBOR. Choosing a historic median has produced a fallback value that was closer to the actual IBOR rate. Below are two tables (in bps) comparing the average absolute difference between the fallbacks (using the historic mean and median) to IBOR since the start of 2016.

Comparison of fallbacks (using the historic mean and median) to IBOR since the start of 2016

Comparison of the average absolute difference between the fallbacks (using the historic mean and median) to IBOR since the start of 2016

Fig 6 CHF 3m LIBOR vs historic fallbacks

Figure 6: Comparison of Fallback using the historic approach and 5-year mean and median and 10-year mean and median compounded in arrears

2.3 Response to general questions

2.3.1 How important or unimportant is it for the fallbacks to be approximately present-value neutral at the time of trigger?

Chatham would like to respond to this question in the case when markets are functioning normally and when markets are not functioning normally, for example when they are illiquid.

Fallbacks that are approximately present value neutral are fair to market participants. Fallback methods that are not present-value neutral have the effect of transferring value from one party to another. While the change to a fallback will be disruptive, fallbacks that are approximately present-value neutral will give market participants the option of further hedging changes related to the transition without incurring immediate losses. If the fallback is not approximately present-value neutral, then the value transfer will be locked in once the fallback method is announced. Market participants will not have good alternatives to compensate for their losses because changes in hedging structure after the fallback do not make up for the losses incurred because of the fallback method.

Additionally, when markets are functioning normally, Chatham’s view is that fallbacks should prioritize being approximately present-value neutral at the time of trigger. Fallbacks that are approximately present value neutral help ensure markets transition smoothly and minimize disruptions at the time of trigger. This position is in accordance with the guidance provided by the FASB. In early drafts of transition relief language for hedge accounting purposes, the FASB has indicated that little to no value transfer would be an important qualifying criterion for hedge accounting to be maintained. As a critical change to the terms of a derivative would result in the cessation of hedge accounting, the FASB intends to put in place a one-time exception for derivatives that transition from an IBOR benchmark rate to another benchmark rate. Minimizing the value transfer will be important to ensuring that this intended relief materializes.

When markets are illiquid, then the assumptions in most derivative valuation models start to break down. So even if it is possible to calculate a present value of a derivative in certain markets, those values may have very little relationship to true value. Fallback methods that do not rely on the present value of the derivative will then need to be examined.

2.3.2 How important or unimportant is it for the fallback rates to be available in advance of the accrual period? Alternative, is setting in arrears acceptable?

Ideally, Chatham would prefer that a term structure develop for derivatives, which would eliminate the need for either the setting in advance or the setting in arrears methodologies. From an end user’s perspective, term rates would be easier to implement and there would be fewer operational difficulties associated with implementing a term structure.

With that being said, in accordance with Chatham’s earlier comments, Chatham believes that a setting in arrears methodology is the preferred methodology relative to the setting in advance. While the setting in arrears does pose certain operational difficulties for end users specifically around not knowing the rate until the end of the term, Chatham believes that this issue can be solved through the use of payment lags or other means to provide end users with more time once the final rate has been calculated. Overall, Chatham believes that incorporating any rate hikes/declines into the current term instead of having a lagging calculation methodology is a more important feature for the term fixing structure. 

2.3.3 How important or unimportant is it for the fallback rates to be wholly (or mostly) convexity free?

The fallback rates should be mostly or wholly convexity free. The term rate used in the fallback can have convexity, or some uncertainty in the interest rate over the interest rate period. The spot rate has convexity. The compound in advance and convexity adjusted spot rates have reduced convexity. The compound in arrears rate is convexity free and was therefore preferred over the compound in advance rate.

2.3.4 Recommendation for USD LIBOR/SOFR

Chatham’s approach to USD LIBOR/SOFR would be very similar to our approach to this consultation. Focusing on fairness, implementation and manipulation potential of the different fallbacks, Chatham recommends the use of Ranking System 1 for USD LIBOR/SOFR. To confirm this approach, given that the Forward Approach is ranked first, it will be necessary to see whether the USD LIBOR and SOFR derivatives markets are liquid enough to generate robust forward curves. Additionally, it would be necessary to clarify if the historic SOFR indicative rates can be used for the Historical Mean/Median Approach.

2.3.5 Ability to Transact Using Definitions that Incorporate Fallbacks

Chatham believes that there are certain derivative products where it may be challenging to transact using definitions that incorporate fallbacks. Specifically, Chatham has concerns regarding how the fallback methodologies will impact interest rate caps and option products more generally. Chatham’s concerns relate to the fact that it can be very difficult to value an interest rate cap using the proposed fallbacks. Interest rate caps are a common hedging strategy used by end users when borrowing using floating rate debt to set a ceiling on the interest rate that they may need to pay under the borrowing facility. Without the ability to value the product, market participants will be less likely to use caps as a hedging strategy.

2.3.6 Implications of Using Different Approaches Across Different Currencies

There are potentially problems with using different fallback methods across different currencies. Differing fallback language on a floating-floating cross-currency swap that is not harmonized could cause issues around calculation periods, cash flow dates, etc. For example, in an XY cross-currency swap where X uses a fallback provision with a Compounded Setting in Arrears Rate and Y uses a fallback provision with a Compounded Setting in Advance Rate, there will be a mismatch between when the payment on each side of the cross-currency swap is known. All things considered, minimizing value transfer is a far higher priority than the operational challenge of managing inconsistencies across fallback methods.

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