Response to ISDA's supplemental consultation spread and term adjustments for USD LIBOR

Supplemental consultation on spread and term adjustments for fallbacks in derivatives referencing USD LIBOR, CDOR, and HIBOR and certain aspects of fallbacks for derivatives referencing SOR

Executive Summary

Consistent with our reply to ISDA’s July 2018 consultation on Certain Aspects of Fallbacks for Derivatives Referencing GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen, TIBOR, and BBSW (the July 2018 consultation), Chatham continues to believe the key criteria for determining appropriate fallbacks are minimizing value transfer, ensuring ease of operational implementation, continuing hedging utility, and robustness. Chatham has evaluated the fallback alternatives offered by ISDA in this supplemental consultation, against the key criteria and prefers a compound setting in arrears rate and a forward spread approach that keeps the valuations present value neutral on the trigger date. Chatham prefers the forward spread approach because it constitutes a market-based mechanism for price discovery, even considering the difficulties inherent in creating a robust forward spread approach.

In contrast with Chatham’s response to the July 2018 Consultation, Chatham no longer ranks or supports the historic mean/median spread adjustment approach because Chatham has observed that U.S. market conditions have changed since the release of the July 2018 fallback consultation through today. Specifically, Chatham has observed that forward spreads between LIBOR and risk-free rate (“RFR”) proxies have meaningfully converged to their static historic averages.

In addition, Chatham cautions against omitting alternatives that could provide better market fit, prevent or reduce value transfer, and lower transition costs for end users. Given the heterogenous needs of derivatives end users, a one-size-fits-all approach could lead to substantial market disruption. While derivatives used to hedge exposures arising from LIBOR-indexed cash instruments accounts for a subset of the current open interest in LIBOR-based derivatives, given the significance of this market segment to U.S. economic activity, it needs to be prioritized for discussion. It is critical to remember that the primary function of derivatives markets is to serve the needs of end users for price discovery and risk mitigation.

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

1. Market impact and considerations

Chatham has observed that forward spreads between USD LIBOR and a SOFR proxy (compounded Fed Funds) have flattened out since July 2018 and are in line with historical averages. Forward spreads between 3-month USD LIBOR and compounded Fed Funds, on average, tend to widen with time, reflecting the increasing impact of credit risk by markets. This tendency held true before 2018, as illustrated in the figure below, which reflects forward spread curves calculated on a specified date in their labeled year. Since July 2018, however, markets have changed. In particular, the spreads in LIBOR and Fed Funds forward curves have flattened out. The forward spread is in line with the consensus 5–10-year historical spreads that would be used to calculate the LIBOR fallback.

Chatham believes that ISDA’s July 2018 consultation made considerable effort to minimize disruption to markets at the time of the trigger date. However, Chatham observes that these changes in the term structure of the forward credit spread in U.S. markets appear to be correlated with the release of the results of the July 2018 consultation. As reflected in the plots below, the basis between 2-year and 30-year LIBOR-Fed Funds basis swaps, recently at historic lows and signifying the flatness of the forward credit spreads, moved considerably on the day that the initial summary of the consultation was released.

In light of the potential market impact of releasing consultations and their corresponding results, Chatham recommends that ISDA consider conducting a review of the impact of the July 2018 Consultation on the calculated spread, especially if the historical mean/median approach is preferred for the USD LIBOR replacement rate. Chatham would appreciate the opportunity to provide further discussion on this topic.

2. Responses to questions

Question 1: Based on the results of the July 2018 Consultation, the compounded setting in arrears rate approach and the historical mean/median approach will be used to calculate the fallbacks for GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen, TIBOR, and BBSW. Is the compounded setting in arrears rate approach and the historical mean/median approach also appropriate for fallbacks for USD LIBOR, CDOR and HIBOR? Please explain why or why not.

Chatham believes that of the approaches considered, the compounded setting in arrears is most appropriate and applies for USD LIBOR, CDOR, and HIBOR. The reasons in favor of the compounded setting in arrears rate are detailed in our response to the fallback consultation. One of the strongest reasons in favor of the arrears rate is that it reflects the market rate conditions of the period in question. Chatham also listed disadvantages to the arrears approach, and those disadvantages also apply to the IBORs covered in this consultation. We also believe that other alternatives, such as forward-looking term rates, could also be included in fallback waterfalls for additional flexibility.

Chatham continues to favor the forward approach over the historical mean/median approach for calculating the spread adjustment as the forward approach would keep valuations more present value neutral on the trigger date. In contrast with Chatham’s response to the July 2018 consultation, Chatham no longer ranks or supports the historical mean/median approach because Chatham has observed that U.S. market conditions have changed since July 2018. Specifically, Chatham has observed that forward spreads between LIBOR and RFR proxies, have meaningfully converged to their static historic averages.

Question 2: If the compounded setting in arrears rate approach and the historical mean/median approach are not suitable for fallbacks for USD LIBOR, CDOR and HIBOR, is another combination of approaches more appropriate?

Please refer to our response to ISDA’s July 2018 consultation for a full description and analysis describing Chatham’s preferred ranking. In that response, along with an explanation of why Chatham favors the arrears to advance term approach and why Chatham does not believe Spot Overnight Rate and Convexity-adjusted Overnight Rate are suitable options. Our previous response is still generally applicable for the IBORs covered in this consultation; however, given current market conditions, Chatham now only supports the forward approach for spread calculation and ranks the methods in order of preference as follows:

Chatham no longer ranks or supports the historic mean/median approach due to the market observations that are detailed in section 1. Specifically, Chatham has observed that forward spreads between USD LIBOR and a SOFR proxy (compounded Fed Funds) have flattened out since July 2018 and are in line with historical averages, in contrast to the historical tendency for these spreads to widen with time. As a result, spreads have meaningfully converged to what the historic mean/median approach would be.

The forward approach allows for price discovery for any counterparties looking to negotiate away from LIBOR and would allow the spread to evolve based on market forces rather than remain static based on historic spread calculations.

Question 3: Please indicate whether you would not be able to transact using definitions that incorporate fallbacks based on the compounded setting in arrears rate approach and the historical mean/median approach. If you would not be able to transact please give specific examples of the types of derivatives for which the fallbacks would be problematic and explain why.

Chatham believes that there are certain derivatives products for which it may be challenging to transact using definitions incorporating fallbacks. Chatham has specific concerns regarding how the fallback methodologies will impact interest rate caps and option products more broadly. These concerns relate to difficulties in valuing an interest rate cap using the proposed fallbacks. Interest rate caps are a common hedging strategy for end users when borrowing using floating-rate debt to set a ceiling on the interest rate payable. Significant challenges in valuing the product could inhibit the use of caps as a hedging strategy among some market participants.

There are also potential problems with using different fallback methods across different currencies. A hypothetical floating-floating cross-currency swap where fallback terms have not been harmonized between legs could create additional risk due to 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. Minimizing value transfer is a far higher priority than the operational challenge of managing inconsistencies across fallback methods.

Question 4: Please provide separate comments on the general appropriateness and effectiveness of each of the four approaches to the adjusted RFRs and three methodologies for the spread adjustments. Please specifically comment on the operational challenges, economic impacts, implications for hedging, feasibility of implementation and any other complexities. Indicate whether your comments apply to all contracts, new contracts only or legacy contracts only. With respect to any operational challenges, please explain how long it would take to overcome such challenges.

Chatham represents end users in the derivatives market and took into consideration the operational challenges for end users regarding each risk-free rate methodology. Please refer to Sections 2.1 and 2.2 in our response to ISDA’s July 2018 consultation for our detailed considerations of the challenges that each approach will present. Chatham believes our response remains applicable for the IBORs covered in this current consultation.

Question 5. Questions about specific methodologies for calculating the spread adjustment.

Unless you are suggesting the use of an approach other than the historical mean/median approach, please only respond to the questions relating to the historical mean/median approach.

(a) Forward Approach

(i) 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? Please specifically consider 5 trading days, 10 trading days, 1 month and 3 months but also indicate whether a different length is most appropriate and explain why.

(ii) What is the appropriate length of the forward spread curve? Please specifically consider 30 years, 40 years, 50 years and 60 years but also indicate whether a different length is more appropriate and explain why.

(iii)Would it be acceptable to use data for cleared transactions only when using the forward approach to calculate the spread adjustment? If so, how should the differential between central counterparties (CCPs) be addressed?

As detailed in section 1, Chatham no longer ranks or supports the historic mean/median approach.

Please refer to Sections 2.2.1 in our response to ISDA’s July 2018 consultation for our detailed response on the forward approach for spread calculation. This response is also applicable for USD LIBOR, CDOR and HIBOR. As noted, Chatham believes sourcing necessary data for the long end of the curve may prove challenging as the market becomes thin. Additionally, there are key pricing differences between different clearinghouses 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 initiate another consultation to vet more specific implementation issues.

Question 6: The Federal Reserve Bank of New York started officially publishing SOFR on April 3, 2018. It has also made available indicative SOFR values dating back to August 1, 2014 and the historical Overnight Treasury GC Repo Primary Dealer Survey Rate (which serves as a proxy for SOFR with a few technical differences), dating back to February 20, 1998. Would it be acceptable to use this indicative and proxy data when calculating the spread adjustment in respect of adjusted SOFR (i.e. as part of a lookback period)? Please explain why or why not.

Chatham recommends using indicative SOFR published by the Federal Reserve Bank of NY dating back to August 1, 2014 in calculating the historic spread adjustment.

We also recommend using the Overnight Treasury GC Repo Primary Dealer Survey Rate (“proxy SOFR”) when calculating a historic spread adjustment dating back before 2014, however we would like to address the differences between proxy SOFR and indicative SOFR. On average, indicative SOFR was 0.91 basis points higher than proxy SOFR over their overlapping time frame. This difference should be considered when calculating the spread adjustment over lookback periods that incorporate both data-sets.

Question 7: SOR is an FX swap implied interest rate, computed from actual transactions in the USD/SGD FX swap market, utilizing USD LIBOR as the applicable USD interest rate. Therefore, a cessation of USD LIBOR would result consequently in a cessation of SOR. To address this risk, ABS Co and the SFEMC have recommended that, in the event of a permanent cessation of USD LIBOR (based on the definition of ‘index cessation event’ described above), an administrator should produce Adjusted SOR as a fallback reference rate based on actual transactions in the USD/SGD FX swap market and a USD interest rate calculated pursuant to the methodology used to calculate fallbacks for USD LIBOR in the updated 2006 ISDA Definitions (i.e. adjusted SOFR plus a spread adjustment). To implement this recommendation, ISDA will update the SGD-SOR-VWAP Rate Option in Section 7.1 of the 2006 ISDA Definitions to provide that upon a permanent discontinuation of USD LIBOR (as triggered by the definition of ‘index cessation event’ above), derivatives contracts that reference SGD-SOR-VWAP will fall back to this Adjusted SOR. Please comment on whether you have any concerns regarding this approach.

We have listed a number of concerns regarding the applicability of the USD fallback methods. While those concerns also apply here, we do not have any additional concerns regarding its use for calculations in the USD/SGD FX swap market.

Balancing merits of different rate alternatives

Chatham and its end-user clients use derivatives to hedge financial risks associated with interest rates, FX, and commodities. Because of the bespoke nature of this segment of the derivatives market, it requires special consideration, and it is important that ISDA explicitly recognize the needs of this segment.

Differences in the currently proposed fallback language for cash instruments published by the ARRC and for derivatives by ISDA create a divergence that introduces basis risk, operational difficulties, and accounting challenges. When entering into derivatives transactions to hedge cash instruments, best practices are predicated on having close alignment between LIBOR cessation triggers, replacement indexes, and spread adjustments.

Fallbacks to forward-looking term rates are currently being contemplated for cash instruments and retail products but not for derivatives. Market experience with compounded rates as IBOR replacements is limited. There is substantial uncertainty around the availability and viability of forward-looking term rates. Compounded SOFR appears to be the favored choice of both the Federal Reserve Board of Governors (FRB) and ISDA, however, efforts to promote SOFR in the U.S. represent a significant reengineering of financial markets that may impose significant costs on end users and frustrate sound risk management practices.

End users may be in favor of term rates for their cash instruments due to their familiarity and the fact that current systems and market practices are based on forward-looking term rates—conceivably making a transition to term rates easier to administer than a transition to compounded rates. However, uncertainties around availability and viability of forward-looking term rates could force participants to use compounded rates, if they are the only reliable alternative available.

End users face a dilemma in evaluating fallback alternatives amongst those proposed by ISDA as the field of potential alternatives appears artificially limited. If ISDA does not include forward-looking term rates for SOFR in its fallback waterfalls, end users may prefer to negotiate fallbacks to forward-looking term rates for derivatives contracts, if they are being used in cash or retail products and are robust/viable. Chatham recommends that ISDA thoroughly consider the implications if a small minority of market participants choose to negotiate fallbacks rather than adhering to a protocol. A lack of adoption by market segments could render the transition that much more challenging and should be considered in depth during the process of developing the new definitions and protocol.

It is also possible that LIBOR alternatives created by other market participants (e.g. AMERIBOR, ICE Bank Yield Index) could have utility as USD LIBOR replacements for cash instruments and derivatives used to hedge them. If they prove robust and viable, end users may seek to negotiate the use of these rates in cash instruments and derivatives used to hedge them as they offer both term structures and a measure of credit exposure.

While end users understand the desire of the FRB to encourage the creation of liquidity for risk-free rate alternatives such as compounded SOFR, the FRB and ISDA should state clearly to the public that market participants are free to develop and adopt other LIBOR alternatives. In fact, given uncertainties of how SOFR-based rates will work in practice, we suggest the FRB and ISDA encourage end users’ ability to choose rates that best suit their needs and actively participate in efforts to determine which rates best fit end users’ needs.

The nature of the bespoke market is that market participants are free to negotiate rates that best suit their needs. However, communications from the FRB, ARRC, and ISDA appear to encourage market participants to adopt compounded versions of SOFR. This has created uncertainty for end users and could discourage the development of IBOR alternatives that may better suit the hedging needs of end users, such as, for example, forward-looking SOFR term rates.