a look inside the libor transition - fincad.com

A Look Inside the Libor Transition:

WHITE PAPER

Combining High Quality Market Data and Powerful Financial Analytics

By: Jonathan Rosen, PhD

ContentsIntroduction .............................................................................................................................3

The Libor Transition and Repercussions for Interest Rate Models ..................4

USD Interest Rate Models .......................................................................................4

Euro Interest Rate Models .......................................................................................5

JPY Interest Rate Models .........................................................................................6

ISDA Protocol ................................................................................................................7

FX .......................................................................................................................................9

Portfolio-Level Impacts ............................................................................................11

Basis Swap Strategies for Libor Leaders .....................................................................13

Conclusion ................................................................................................................................16

A Look Inside the Libor Transition | 3FINCAD | fincad.com

INTRODUCTION

The process of phasing-out the world’s most important interest rate benchmark is already underway. Surrounded by recent scandals, the Libor interest rate benchmark has revealed severe shortcomings, including the subjective rate polling on extremely thin underlying interbank loan markets, which have left Libor open to potential insider manipulation. In the wake of these revelations, a dark shadow has been cast across the future of the Libor benchmark.

The major economies of the world are now amid a swift regulatory thrust to promote alternative benchmarks and simultaneously discourage continued reliance on Libor. In particular, the London-based administration of Libor in major global currencies such as GBP, USD, EUR, CHF, JPY and others are all within scope for potential cessation by 2022.

Today’s firms have a wide range of dealings and business activities that rely on steady funding and accurate matching of assets and liabilities with respect to prevailing interest rates. A firm’s exposure to floating rates can be present in a wide variety of financial arrangements, including fixed income floating rate notes, mortgages, loans and many other securities and derivatives. This has led to the vast majority of businesses having at least some exposure to Libor as an ordinary business practice. However, the imminent cessation of Libor will lead to the inability to continue on this way. So, firms must start considering how to effectively and efficiently move to alternative interest rate benchmarks.

Despite the now apparent drawbacks to Libor, it is the historical importance of this benchmark rate, and the vast array of organizations that continue to use it in daily operations, which lead us to believe that a future dominated solely by alternative benchmarks will be some time in the making. As regulators push the Libor reform movement at different levels of urgency across the different global economic boundaries, regions, and sectors, a multitude of different situations are now arising that are forcing technical practitioners to deal with a host of new challenges. Among these challenges are the following:

1. Understand the scope of current ties to Libor present in various business lines

2. Identify new and existing alternative interest rate benchmarks

3. Incorporate new instruments and test trades in markets emerging for alternative rates

4. Examine the ISDA Libor fallback contract amendments for potential future impact

5. Incorporate Libor fallbacks into all existing and new deals to prepare for possible cessation of the Libor benchmark

6. Decrease Libor-linked investments and ramp up Libor-free strategies across all business areas

The above points are just a brief overview of the minimum set of challenges that are being faced in order to ensure continuity of business up to and beyond the future cessation of the Libor benchmark interest rate. In the following sections these areas of interest will be explored in greater detail, which ultimately will support the conclusion that having the right tools to help guide through the imminent Libor cessation will absolutely require two ingredients: high-quality market data and powerful financial analytics.


This section focuses on the multi-curve modeling approach currently used in major currencies. This is not intended to be a comprehensive overview of every aspect of multi-curve modeling, but instead a sampling of some of the most common modeling approaches, as well as the most important features of these models with respect to interest rate curve construction now and in the future. This includes the process of transitioning away from the widely used Libor benchmark. This section will cover some of the most important changes coming to curves in several different currencies, including the US dollar, Euro, and the Japanese Yen.

A common first step that numerous firms are taking is to put in place the necessary technology to build curves for alternative rates, such as the USD Secured Overnight Financing Rate (SOFR). Many are coming from a starting point of multi-curve calibration involving Libor and overnight index swap (OIS) rates, which is still required in addition to the extra data requirements and analytics required for new curves for alternative rates. Though, this is unnecessary for alternative rates like the Sterling Overnight Index Average (SONIA) that have been around for some time. However, it is not only the case that some new curves are required, but it is now time to start re-thinking existing curves that are highly dependent on Libor-linked instruments.

USD Interest Rate Models

In the case of US dollar interest rates, arguably the most important benchmark is the quarterly Libor rate, with both adjacent monthly and semi-annual tenors having a similarly important role as the major USD interest rate benchmarks. From a benchmark perspective, this distinction is mainly based on the deep liquidity that is currently found around the instruments linked to these tenors. Table 1 presents a typical set of the most commonly traded instrument market data that is available for curve construction in USD. However, it is always possible to include additional instruments when they are available with sufficient liquidity and recency in transaction record and tick-based market data feeds.

Table 1: A typical set of USD curve instruments for the short- and long-end calibration of USD benchmark curves

THE LIBOR TRANSITION AND REPERCUSSIONS FOR INTEREST RATE MODELS

Curve Type Short-End Long-End

US EFFR EFFR Futures EFFR OIS

SOFR Monthly Average and Quarterly Compounding Futures; SOFR OIS

SOFR OIS (or FF Basis/Libor Basis Swaps)

USD Libor 1m Fixing Anchor Libor 1m-3m Tenor Basis Swaps

USD Libor 3m Fixing Anchor, Eurodollar Futures

Semi-annual fixed vs quarterly Libor Interest Rate Swaps

USD Libor 6m Fixing Anchor Libor 3m-6m Tenor Basis Swaps

For a number of years the Effective Federal Funds Rate (EFFR) curve has been the staple for discounting, largely due to its prominent role as the rate earned on collateral and margin accounts, as well as the significant efforts to shore up collateral management throughout the financial system. The EFFR discount curve can be straightforwardly built with a bootstrapping algorithm from market quotes for EFFR futures and OIS. However, it is important to note that this is a policy rate driven by the Federal Open Market Committee (FOMC) of the US Federal Reserve, and any changes to this rate are almost always occurring on pre-announced dates called FOMC meeting dates. This places a restriction on the possible times on which the forward EFFR rate can change, thus modifying the underlying time points of the bootstrapping algorithm to conform to this requirement.

The USD Libor rate is the most commonly used interest rate benchmark in US financial contracts. Typically the quoted interest rate swaps linked to 3m USD Libor are also collateralized transactions, which requires the simultaneous use of the EFFR rate for discounting of future cash flows linked to forward Libor rates. If any Libor-EFFR basis swaps are included in the EFFR curve calibration, then it is necessary to simultaneously build the EFFR and Libor forward rate curves. In contrast, if the instruments in table 1 are used, then the EFFR forward rate curve can be built first and then the Libor curve can be built separately. Simultaneous curve construction can be used for either situation, so it is a convenient approach that suits any choice of curve instrument input for curve construction.


as well as for the OIS instruments, which are used as inputs to Euro discount curve construction.

However the concerns about EONIA being based on bank panel submissions, similar to Libor, has led to the efforts to replace EONIA with €STR. Unlike the US, the Eurozone has taken the elegant approach of simply redefining EONIA to be €STR, plus a fixed spread which has been set to 8.5 bps. The EMMI has stated plans to stop publishing EONIA on 3 January 2022. This timeframe will coincide with the introduction of instruments like OIS that are instead based on €STR. Interestingly enough, despite the simple relation between these two benchmark rates, at the moment both EONIA and €STR OIS are being traded with respective OIS data available for curve construction as shown in table 2 below.

Table 2: A typical set of Euro curve instruments for the short- and long-end calibration of EUR benchmark curves

In contrast, the situation for Euribor is quite different from that of other Libor rates. In particular it is important to note that there are actually two different types of Libor rates in Euro - EUR Libor is based on rates reported by London banks, while Euribor is based on rates reported by banks trading in Frankfurt, Paris, Milan and other places in the Eurozone. While EUR Libor is very much within the scope of the Libor transition, it is also much less commonly used than Euribor, which it turns out is intended to undergo minor reforms and subsequently remain available for the near future as a widely accepted interest rate benchmark. While EUR Libor is still utilized particularly in financial markets outside the Eurozone, the loss of this benchmark should not pose significant challenges due to the very similar Euribor benchmark

The more recently introduced SOFR rate in USD can be easily compared to the EFFR rate. While SOFR has slightly different economic foundations as an average over secured repo transactions, due to the lack of credit risk as compared with Libor, and the significant impact of the Federal Reserve policy rate on SOFR, this means that the nature and behavior of SOFR is very similar to EFFR. This includes a close connection between SOFR forward rates and SOFR OIS market data, in addition to the parallel between SOFR and EFFR futures contracts. This currently means that the standard approaches used to build the EFFR curve can be easily adopted to build the SOFR curve with sufficient accuracy based on published SOFR fixings and available futures and OIS market data.

Figure 1: Major USD interest-rate benchmark curves shown for an approximate 10-year span, as of Oct 13, 2020

Euro Interest Rate Models

In the Eurozone, several interest rate benchmarks have been used for a number of years, both for the short tenor overnight rates as well as long tenor EUR Libor and Euribor rates. Perhaps the most important of these benchmarks in terms of common use in financial instruments are the Euro Overnight Index Average (EONIA), and the 6m Euribor tenor which has behind it the most liquid swaps on the continent, in the form of annual fixed versus 6m Euribor floating IRS.

In the endeavor of interest rate benchmark reform, a new overnight rate has now been introduced as well, the Euro short-term rate (€STR). The current situation with EONIA and €STR broadly parallels the situation with EFFR and SOFR in the US, but also differs in some key respects. Much like EFFR, EONIA has long been an important benchmark used for secured cash


EONIA Cash Rates EONIA OIS

€STR FEI Futures €STR OIS

Euribor 1m Fixing Anchor Annual fixed vs monthly Euribor Interest Rate Swaps

Euribor 3m Euribor FRA Annual fixed vs quarterly Euribor Interest Rate Swaps

Euribor 6m Euribor FRA Annual fixed vs 6m Euribor Interest Rate Swaps


JPY Interest Rate Models

Finally moving across the globe, we can consider the current situation for the Libor transition in Japan. Unlike the previous two examples, Japan is more akin to the UK in terms of having a long-standing overnight rate benchmark that is to remain of central importance as a Libor alternative. The Tokyo Overnight Average Rate (TONAR) is an unsecured interbank overnight interest rate used for cash instruments as well as discounting, based on OIS instruments as shown in table 3. While this does reflect a simpler state of affairs going forward, which does not require adding new benchmarks or curves, the context around this is also important.

Table 3: A typical set of Japanese Yen curve instruments for the short- and long-end calibration of JPY benchmark curves

In Japanese Yen there are parallel sets of Libor benchmarks that apply in different markets. The JPY Libor benchmarks as well as the EuroYen Tibor are mainly used in offshore financial instruments, with the key difference between them being the fact that JPY Libor is administered by the intercontinental

remaining available. However, it should be anticipated that Euribor could eventually be phased out as well, especially if the global efforts to move to alternative benchmarks are ultimately successful.

An important consequence of the regulatory initiative to switch to new overnight rates like SOFR and €STR as alternative benchmark interest rates is that the underlying forward rate market data usually involves models based on OIS instruments. This is just one reason why it is quite important to quickly grow the OIS markets for new alternative rates in terms of liquidity and trading volumes. The OIS market is commonly used for hedging discounting risk among other things, and combined with the fact that until recently USD discounting is mostly done with EFFR, this would hypothetically lead to a complex situation for pricing SOFR OIS involving SOFR/EFFR basis risk. Similarly the €STR/EONIA fixed basis would be relevant if €STR OIS are discounted at EONIA.

The far simpler approach of discounting SOFR OIS at SOFR, and similarly for €STR, has instead been mandated from the start for centrally cleared OIS. This is consistent with the general purpose of SOFR to replace EFFR, and €STR to replace EONIA in widespread use. In order to expand the use of SOFR and €STR OIS and promote the general acceptance of these new rates, discounting and collateral interest rates would ideally need to be switched to SOFR and €STR for all instruments. While this process has already begun with centrally cleared positions, it is not possible to enact these changes unilaterally for OTC derivatives under existing collateral CSAs, so the probability of ongoing basis risk is much higher for these positions.

Figure 2: Major Euro interest-rate benchmark curves shown for an approximate 10-year span, as of Nov 5, 2020


TONAR Cash Rates TONAR OIS

JPY Libor 1m Annual fixed vs monthly Libor Interest Rate Swaps

Libor 1m-6m Tenor Basis Swaps

JPY Libor 3m Libor FRA Libor 3m-6m Tenor Basis Swaps

JPY Libor 6m Libor FRA Semi-annual fixed vs 6m Libor Interest Rate Swaps

EuroYen Tibor 1m

Fixing Anchor Tibor EuroYen 1m-6m Tenor Basis Swaps

EuroYen Tibor 3m

JEY Futures Tibor EuroYen 1m-3m Tenor Basis Swaps

EuroYen Tibor 6m

Fixing Anchor Semi-annual fixed vs 6m Tibor EuroYen Interest Rate Swaps

JPY Tibor 6m Fixing Anchor Semi-annual fixed vs 6m D-Tibor Interest Rate Swaps

USDJPY Fwd FX Rate

FX Forwards/Swaps

Cross-Currency Interest Rate Basis Swaps


ISDA Protocol

Beyond the updates to the coverage of multi-curve models and discounting updates discussed above, the next imminent event in the Libor transition process is the acceptance of the ISDA protocol amendment for Libor fallbacks. This is a very important step in updating the contractual language around Libor cessation for derivatives that fall under the original ISDA master agreement that is widely used for OTC derivatives. It was recognized that the original language of the agreement was insufficient to ensure the clear identification of an alternative rate in the event that Libor publication was ceased. Over the past two years, a number of consultations have been carried out to determine the most widely preferred fallback language. Now that this has concluded, the current effort is to ensure that all relevant parties sign onto this protocol amendment to robustify their financial contracts in the event of Libor benchmark cessation.

The finalization of the language and technical details of the ISDA Libor fallbacks has determined that an in-arrears compounded overnight rate will be used, as well as a 5 year historical median credit spread adjustment being applied to arrive at the final fallback rate. Now that these details are known, it is possible to determine what the most likely fallback rate will be for

exchange based out of London, while EuroYen Tibor is instead administered by the JBATA in Japan. Both benchmarks are currently within the scope of the Libor transition, however it is possible that efforts to preserve EuroYen Tibor by unification with domestic JPY Tibor will ultimately result in an increased longevity of the EuroYen Tibor benchmark. Conversely, JPY Tibor is a domestic Japanese benchmark that will continue to be used for onshore financial instruments, much like Euribor in the Eurozone.

Figure 3: Major Japanese Yen interest-rate benchmark curves shown for an approximate 10-year span

derivatives, and this can be directly compared to the interest rate basis in each currency, as shown in figure 4. The results are interesting, and show a range of agreement with the ISDA spread adjustments based on the particular currency and sub-curve in question.

In the case of USD, very close agreement exists between the market basis levels and the ISDA spread adjustment as calculated from historical interest rates. This suggests that the markets as a whole anticipate the ISDA protocol taking effect, such that the fair value of market instruments is governed by the ISDA spread adjustment methodology. This convergence is not observed to apply nearly as much to the Euribor benchmark, which is understandable because the expectation is that Euribor will remain for some time. This would suggest that trades based on EUR Libor will now show marked divergence in market value from identical trades based on Euribor. Another interesting situation exists in the case of JPY, such that the JPY Libor market implied basis levels are fairly close in particular at the short end to the ISDA spread adjustments, while the longer-lived Tibor benchmarks appear to be driven by much different market behavior.


Figure 4: Comparison of forward rate spreads to compounded alternative rates over the respective tenor, compared with the 5-year historical median spread as prescribed by the ISDA protocol


FX

Lastly, we can use the above example for the situation in Japan to consider an area that is not often discussed with relation to the Libor transition, which is that of foreign exchange rates. In particular, the USDJPY FX pair can be examined, since it is one of the most important FX pairs in terms of usage both within Japan as well as globally. While up to now the focus has been largely on the Libor rates themselves, what we find is that they are relevant to a large number of financial markets and asset types, including FX rates.

One of the clearest examples of this is for cross-currency interest-rate basis swaps (CCIRBS), which

can typically pay Libor-linked cash flows in both currencies over the life of the instrument. We can consider a situation where the Libor transition is not necessarily applicable to a EuroYen Tibor leg, yet is applied as widely anticipated to the USD Libor leg of the swap. This illustrates an unbalanced situation where the impacts of the USD Libor transition are felt by the Japanese investor using CCIRBS to secure USD funding. Even without any significant changes to the benchmark interest rates in Japan, this investor could still be exposed to a sudden change in basis risk and cash flow mismatches that can ultimately impact their balance sheet either directly or indirectly.

Figure 5: Impacts on USDJPY forward rates (top right) and USD FX-Implied forward rates (top left) from an asymmetric Libor transition affecting USD Libor but not JPY Libor. Market risk impacts (DV01) for positions depending on USDJPY FX forward rates are shown at bottom.


As an example we can consider a simple portfolio of a single USD commercial loan swapped into JPY with a CCIRBS and apply the ISDA protocol starting in Jan 2022 to observe the portfolio impact. What we see in figure 6 is that the USD-only nature of the scenario for Libor cessation, together with the close convergence of the USD basis spreads to the levels set out by the ISDA protocol result in very little impact on portfolio value or future projected cashflows. However this is not the case for the portfolio risk (as measured by sensitivity to individual market quotes), which in terms of the forward fixings shows a drastic, though anticipated change towards alternative rate fixings.

Figure 6: Valuation impact, fixings risk impact, and market risk impact summary for USD loan portfolio together with CCIRBS from the view of Japanese domestic market investor

Perhaps less anticipated are the changes to the portfolio market risk, in terms of quoted instruments by instrument type and maturity. In this multi-currency portfolio, the original market risk is very straightforward and only involves the 5y maturity USD IRS and USDJPY CCIRBS. However in the scenario of Jan 2022 USD Libor cessation, not only does the market risk change to SOFR OIS instruments, but the tenor composition is far more variable, and in particular shows sensitivity to shorter maturities near the Jan 2022 time that is between the 1y and 18m maturities. The sudden appearance of market risk to maturities around the cessation time point is an interesting consequence of the details of the switchover from existing USD Libor curves to in-arrears compounding methodology for fallbacks based on the SOFR alternative benchmark.


Portfolio-Level Impacts

One of the clearest examples of the potential impact of the Libor transition is the fact that the ISDA fallback protocol is not designed to be inherently value-neutral. A multi-currency portfolio value and cash flow impact analysis in Figure 7 shows there is the complete possibility that the current market value of an investment portfolio can change as soon as the Libor cessation event is scheduled or known. Going from the existing interest rate curves for Libor to the calculation of Libor fallbacks based on alternative forward rates is essentially a change to the payout of any derivatives that are currently based on Libor. However, in the situation that the Libor benchmark

cessation is actually known or anticipated well in advance, it is likely that the markets will actually trade very closely to the fallback levels so that in practice much of the potential value transfer should be mitigated at the actual time of Libor cessation. This suggests that it is important to take every possible step to anticipate the impacts of the Libor transition, since the valuation impact will largely occur before the actual time of the benchmark cessation. The best approach for managing a portfolio through the Libor transition is to get the necessary tools in place to closely monitor the market-driven impacts to the positions.

Figure 7: Valuation and cash flow impacts summary is shown for a sample multi-currency fixed-income portfolio including GBP, EUR, JPY, and USD trades, and assuming Jan 2022 Libor cessation across all currencies with ISDA protocol fallbacks taking effect.


But this also comes with an interesting caveat, in that an increasingly certain Libor cessation event may very well coincide with a minimal valuation impact scenario, yet it will simultaneously begin to have sweeping and fundamental implications for managing market risk. This is due to the very same redirection of Libor-linked payouts to the alternative-rate-based Libor fallbacks. This is seen in Figure 8, which shows the DV01 aggregated across all curves at each timepoint, in terms of curve instruments in each respective currency before and after the ISDA

fallback is imposed in Jan 2022. Since fallbacks are essentially driven by alternative rate curves, the market risk is driven by a vastly different collection of instruments than that of the Libor benchmark curves. In this very real and upcoming scenario, the market risk of existing Libor-linked portfolios will switch to a new collection of market instruments linked to the alternative rates. It will therefore be particularly important to evaluate hedges and be prepared to use alternative rate instruments for risk management.

Figure 8: Market risk implications viewed in terms of curve DV01 from a Jan 2022 Libor cessation event leading to the ISDA protocol taking effect for USD, EUR, and JPY


There are still yet a number of areas in which it will be important to monitor the impacts of the Libor transition beyond value transfer, value compensations, market risk, discounting rate changes, and forward rate fallback technical definitions that have been briefly touched on here. One of the additional concerns is the potential for different types of instruments to move to different fallbacks for their respective Libor-linked payouts. This might be most significant in the case of cash products, as well as some more exotic derivatives, where the use of in-arrears fallback rates as suggested by the ISDA protocol is not at all suited to these instruments.

For cash products it is essential to be able to know the appropriate rate for a given lending period in advance, which at a minimum requires in-advance rates but ultimately leads to a strong preference for alternative term rates that are structured more similarly to Libor. Another example is for forward rate agreements and the so-called Libor in-arrears derivatives, both of which pay the Libor term rate at the start of the rate period. Since the in-arrears compounded rate cannot be calculated until the end of the rate period, once all the underlying overnight rate fixings have been published, it is not possible to use the ISDA

methodology for these products. Having the ability to model different types of fallbacks, including the in-arrears, in-advance, as well as the lookback, lockout, and payment delay features that have been used in various settings - and to assign these different fallback definitions to different sets of instruments allows a better understanding of the potential hedge mismatches and basis risk which could be unavoidable when Libor cessation takes place.

Under the possible future scenarios of multiple impacts to market value and risk, from all of the previously mentioned sources, it is important to have the right systems in place which are able to clarify the extent of these impacts. The better the technology and state of readiness by all market practitioners, the better their ability to understand and negotiate favorable terms through the course of the Libor transition. Ideally this could even allow for very specific arrangements in some cases that are agreed on bilateral and mutually beneficial terms. However, without widespread clarity, a unilateral acceptance of the ISDA protocol may be a necessary step for many firms in the near future. In this situation it is best to be prepared with a thorough understanding of the implications of the ISDA protocol and related fallbacks for cash products going forward.

BASIS SWAP STRATEGIES FOR LIBOR LEADERS

The end result of getting the necessary data and analytics in place to understand the implications of the Libor transition on a portfolio is to be in a position to formulate optimal strategies for migrating Libor-linked investments to alternative rates. While the baseline approach is essentially to do nothing except sign onto the ISDA protocol and wait for Libor cessation, so-called Libor leaders are instead looking to take-charge of their Libor exposure before that happens. It can be shown that there are opportunities for Libor leaders to achieve a net basis-spread that is better than the ISDA protocol.

The first consideration is how to achieve a complete Libor offset. Interestingly, market basis swaps between Libor and alternative rates can exist for multiple tenors of Libor. Thus, in theory a forward starting offsetting basis swap can perfectly offset any given annuity based on Libor floating rates,

effectively replacing the Libor-linked floating leg with one that instead used alternative floating rates. Even in situations where highly bespoke forward starting positions are not available, at very specific times in the future the same alignment exists between the remaining future cash flows of legacy trades and spot-starting, on-market alternative rate basis swaps. By performing a careful analysis of existing Libor exposures, and projecting future fixings risk onto market basis swaps, a fairly compact set of potential alternative rate basis swaps can be derived, which will completely offset any future Libor exposures. This is demonstrated in figure 9, which shows the complete offset of Libor fixings risk in a large USD fixed income portfolio. Until the potential offsetting basis trade opportunities are identified for a given portfolio, it is impossible to understand the market-implied cost of leading the Libor transition.


Figure 9: Fixing risk (top left) for USD fixed income portfolio composed of roughly 5000 legacy positions in interest rate swaps with floating rate Libor tenors 1m, 3m, and 6m. Top right shows the updated fixing risk once basis swaps are carried out to exactly offset Libor exposures. Bottom figures show that total interest rate fixings delta risk is preserved.

One potential criticism of this approach is that it may require a fair number of basis swap trades which can potentially be costly in terms of position fees, portfolio management requirements, and other potential considerations. However, it is useful to consider these costs relative to the cost of doing nothing, which is effectively the ISDA protocol implied basis.

Figure 10: Example of monitoring key basis swap positions for Libor compression strategies. At left is the trailing daily basis spread over the previous week, relative to the ISDA protocol spread adjustment, for a monthly SOFR/Libor basis swap, which is identified as the most effective offsetting position for a sample portfolio. At right is the same analysis for a quarterly SOFR/Libor basis swap.


To illustrate this we can begin from the previous observations of market convergence to the ISDA protocol basis levels. For example, in the case of USD Libor a near, but still imperfect, convergence currently exists between the basis markets and ISDA spread adjustments. The variability of the market spread levels however show that it is still possible for the basis between Libor and alternative rates at any given moment to deviate from the ISDA fallback spread adjustment. In Figure 10, it is shown that the monthly SOFR/Libor basis has recently gone below the current 5 year historical median spread, which may be an opportunity to offset some existing legacy Libor exposures at levels with an advantage over the wait-and-see approach.

This strategy effectively entails identifying a time-horizon for active efforts to offset legacy Libor exposures. Subsequently the potential forward starting or future spot trades need to be identified, which represent a reasonably compact set of offsetting positions against the legacy exposures. In addition, by studying the recent market behavior of the relevant potential offset trades, well-informed limit orders can be booked such that the Libor transition can be executed against a given portfolio in such a manner as to be more cost effective than signing onto the ISDA protocol and waiting for benchmark cessation to occur. Of course there is some potential for the ISDA-implied spread levels to slip somewhat but given the low rate outlook and the upcoming time horizon of Libor benchmark cessation, it is not likely that the ISDA spread will change drastically from current projections.

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CONCLUSION

It is evident that there is a staggering amount of incredibly useful information contained in the markets about the current state of progression for the Libor transition. Despite this fact, it is still not possible to directly see the full extent of what is currently happening without going a step further. Using the market data as input to analytical tools that build interest rate models, perform portfolio-level projections for valuation and risk management, and derive information from the market data that is directly applicable to a given investment strategy, it is possible to get the most out of the market information. This will help users of these tools stay ahead of the sweeping changes that are coming to the world’s most important interest rate benchmarks.

Currently there have already been significant changes in the types of interest rate benchmarks that are used in market instruments. In the major currencies of USD and Euro, new markets are being forged for the new transaction-based alternative rates, requiring systems that can process these new instruments, as well as construct realistic curves for trading and risk management. But this is only the beginning, because as the certainty builds around the timing

and scope of the Libor cessation event, markets will move further to converge to industry-accepted fallback methodologies, and the landscape of market risk will change dramatically. The level of uncertainty that currently exists in some areas could be seen as an advantage as, for now, it is still possible for markets to trade away from the fallback levels. However, the ability to capitalize on these uncertainties is temporary since the writing may be on the wall in terms of how markets will react to increased certainty around benchmark cessation.

Using powerful analytic tools to analyze current positions, and devising potential routes to mitigate exposure to the Libor benchmark can inform next steps. Taking this approach can help determine the appropriate future times and associated market levels that can be taken advantage of for short-lived opportunities to improve returns over the industry-wide standardized approach. Combining the rich information available from the markets with the right tools to understand and leverage this information is ultimately the best way to not only manage the risks inherent to Libor cessation, but also to seek a competitive advantage through the Libor transition.

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