The cold legacy non-linear solution lies within the ICE Swap Rate formula

15 February 2021

Phil LloydHead of Market Structure & Regulatory Customer Engagement

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While some argue the non-linear market is for the few rather than the many, solutions with regards to transition away from LIBOR¹ remain very important. Only recently did we update on wider developments.

The ISDA² Fallback Protocol does not cover the LIBOR ICE³ Swap Rate (ISR), meaning it leaves swaptions (and some other products) that reference this rate with no adequate fallback. The proposed replacement for GBP LIBOR ISR set out in the paper on 12 February provides a way forward for legacy contracts still referencing this rate come cessation.

The RFR⁴ working group acknowledged the need to support the transition of legacy contracts and the possible use of GBP swap rates such as the GBP SONIA⁵ ISR as a building block is consistent with this approach. The paper published on 12 February is to document how the NLTF⁶ has been considering the use of SONIA swap rates to develop a potential methodology for a replacement for GBP LIBOR. This paper is intended to support market participants’ use of non-linear derivatives, structured products and cash market instruments that reference the GBP LIBOR ISR, in their efforts to meet the target milestones in the Working Group’s roadmap and priorities for 2021.

The formula seeks to minimise changes in valuations whilst being fairly simple to calculate, specifically:

GBP SONIA ISR for relevant tenor, plus
Fixed spread adjustment, published by Bloomberg and applicable to GBP LIBOR fallbacks, plus
The convexity adjustment calculation to compensate for the varying payment frequencies between the fixed and floating legs of the GBP SONIA ISRs and the GBP LIBOR ISRs

Worth noting that this formula is intended for use after the cessation or non-representativeness of GBP LIBOR. The formula assumes that the ISDA Spreads for the various GBP LIBOR tenors have been fixed as the result of an announcement regarding the cessation or non-representativeness of GBP LIBOR. To apply this formula before the cessation or non-representativeness of GBP LIBOR would incur potential inconsistencies between the crystallised ISDA Spreads and the prevailing spreads between GBP LIBOR fixings and compounded SONIA for the respective tenors.

The replacement formula could be adapted to other markets where the discontinuation of the relevant ISRs is likely to trigger similar challenges. The ARRC⁷ in the US has expressed an interest in this approach and, as a result, the NLTF on behalf of the Working Group and the ARRC have agreed to engage in an international collaboration aimed at addressing this topic amongst others.

Existing trades will not automatically switch to pointing at this new rate & will require updating but that can be another conversation. Enjoy the paper.

1	LIBOR	London Interbank Offered Rate
2	ISDA	International Swaps and Derivatives Association
3	ICE	Intercontinental Exchange, Inc.
4	RFR	Risk Free Rates
5	SONIA	Sterling Overnight Index Average
6	NLTF	Non-Linear Derivatives Task Force
7	ARRC	Alternative Reference Rates Committee

Libor

Sonia

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