...try, try again? Whilst we know HOW the spread adjustment will be calculated for derivatives we still don't know WHEN it will be triggered.
On 5 February ISDA announced another consultation on pre-cessation triggers. Under pressure from the regulators (see FSB and FCA letters) and in the light of a consultation from LCH, ISDA is asking the market to think again.
Haven't we been here before?
Last time round in May 2019 there was no consensus on how to handle pre-cessation triggers – i.e. what happens if the regulator determines that LIBOR "is no longer representative" ahead of permanent cessation. There was insufficient agreement on the best approach and it was left that fallbacks would only be triggered by the permanent discontinuation of LIBOR (and who knows how long we might wait for the number of panel banks to drop below five?).
This time the consultation, due out later in February, will ask again whether to hardwire a non-representative pre-cessation event in to the triggers for fallbacks and given the LCH move, it is highly likely that the market will agree to them. In the seemingly unlikely event respondents don't support the new triggers, then ISDA will provide an opt-in instead, both in the 2006 ISDA Definitions (for go forward) and in the protocol (for legacy positions)
This will mean publication of the protocol, originally expected in Q1, will be delayed, though it is not clear yet by how much. That could have knock on impacts on other transition efforts.
LCH weighing in
On 27 January LCH published a consultation with regards to rule book change for automatic triggers into fallback arrangements where a regulatory authority determines an existing benchmark to be non-representative (see Itchy Trigger Finger for our take last year on panel banks dropping out). LCH asked members to comment on the consultation by 23 March.
While the end of LIBOR has been discussed, the LCH announcement has really left ISDA and the bilateral market little choice but to get on with pre-cessation trigger implementation. If they don't it risks a real disconnect between cleared and bilateral markets.
The ISDA consultation does run the risk of coming back with no clear consensus again. If no consensus, then ISDA will allow market participants to 'opt-in' to the pre-cessation fallbacks with others that also opt-in. So we could end up with a split between the opt-ins and the opt-outs.
Don't lookback in anger
There is some ambiguity around when the spread adjustment lookback period will be calculated from. In their latest consultation LCH talks about a lookback period from the pre-cessation effective date, rather than the pre-cessation announcement date. In the previous fallback consultation ISDA indicated that the lookback would be from the announcement date of the permanent index cessation event.
Now ISDA are consulting on pre-cessation again, we would hope that sense will prevail and these date inconsistencies will get ironed out... ISDA may propose different language that aligns with LCH, or following feedback, LCH may tweak it’s change to match ISDA's. It’s hard to imagine LCH wanting to go out on their own and use a different lookback date from ISDA if both are referencing the same pre-cessation trigger. Surely much better for the market and safer for LCH to make sure they piggy-back off the work done by ISDA and Bloomberg to completely align the application of the calculation in the rulebook for the date as well as the methodology?
If you want a refresher on what's a fallback, how it is calculated etc have a look at the recently released FAQs jointly drafted by ISDA & Bloomberg.
See below for where we think the new lookback will end up post both consultations... noting LCH will likely change their position if the outcome of the ISDA consultation goes with the earlier date, and our concern about the disconnect with cash market discussed further below:
What about the cash market?
While we may have reduced the likelihood of the market having a 'zombie' LIBOR for derivatives we still need to discuss the disconnect with the cash market. The concern that derivatives fallback would be triggered at a different time to cash was one of the key concerns of the first pre-cessation consultation, and that worry hasn't gone away. Many legacy bond products pre-2017, the so called “tough legacy”, have no triggers or fallbacks at all.
For now the cash market is focused on preventing bonds reverting to the last coupon (i.e. fixed rate) – there are consultations on fallback spread adjustment methodology for cash underway in both UK (closing 6 Feb) and US (closing 6 Mar) for new LIBOR cash products. Once that's in a better place we're sure focus will move to triggers for new LIBOR cash products (the Sterling RFR consultation does mention pre-cessation triggers, but it leaves them to a future date for further discussion).
For tough legacy how might a 'synthetic' LIBOR be created and used while still being classified as non-representative?
Onwards and upwards
The inevitable delay caused by the new ISDA consultation is a concern, but the path to LIBOR's demise was never going to be all trouble-free.
If as a result of this delay we end up with better alignment between cleared and bilateral then it's been worth it, appreciating aligning derivatives, cash and tough legacy remains a challenge. Taking a step back before moving forward is sometimes the best approach.