Libor-in-arrears swaps face unwinds on benchmark death

Backward-looking fallbacks are incompatible with the product, which relies on forward rates

Backward-looking fallback methodology could force unwinds of swaps that require forward rates to settle

The death of Libor could result in the forced unwind of so-called Libor-in-arrears swaps, which require a forward rate to settle. That is likely to happen if Libor – a forward-looking benchmark – is replaced with a backward-looking fallback rate for swaps straddling the pre- and post-Libor worlds.

“A Libor-in-arrears swap without a forward-looking fixing would be impossible. The best thing to do would be to somehow try and unwind them,” says a rates trader at a European bank.

An industry consultation last year – focused on the Australian, Japanese, Swiss and UK versions of the discredited benchmark – found that most derivatives market participants would prefer Libor-based contracts to fall back to a compounded overnight risk-free rate, which can be set only at the end rather than the start of a given period. Such a fallback will become necessary if Libor disappears at some point after 2021, when panel banks will no longer be compelled to maintain it.

That won’t work for Libor-in-arrears swaps. In a standard interest rate swap, two parties exchange a fixed rate for a floating rate for a period, with the floating rate – typically based on Libor – set at the beginning of the period and paid at the end of it. For Libor-in-arrears swaps, the floating rate is both set and paid at the end of the period.

These contracts became popular in the 1990s as a way for investors to bet that Libor would fall in the future. The forward-looking nature of Libor is therefore an indispensable part of the product. While building a forward-looking term structure for overnight rates is possible for new products, contracts that exist at the time of Libor’s death may only have the option of using the backward-looking fallback mechanism. As a result, some dealers believe the products would have to be unwound at that point.

“You’re not going to be able to use these fallback methodologies for these contracts,” says a rates strategist at the second European bank. “It’s going to be a difficult product for the markets going forward.”

The fallback language being developed by the International Swaps and Derivatives Association is designed to be inserted into new and existing derivatives contracts, to provide a way for the products to move off Libor should a trigger event be activated – for instance, if the rate is no longer published.

Isda is yet to consult on fallbacks for contracts referencing the US dollar Libor and its euro equivalents, but it’s unlikely a forward-looking option will be available. In Europe, though, respondents to a recent consultation by the industry-led working group on euro risk-free rates called for a forward-looking term rate to be used as a fallback for derivatives products.

Broader impact

Since Isda published the results of its consultation in December, some market participants have expressed concern about products whose defining feature is their forward-looking reference rate, saying they will no longer work post-2021 and those who trade them will be reluctant to sign up to an industry protocol that will insert the fallback language into swaps contracts en masse.

“It is a real choice of the people entering into the trade. There is no way you can force them to repaper in a standard way against their will,” says one London-based quant.

In addition to Libor-in-arrears swaps, forward rate agreements (FRAs), caps and floors are some of the derivatives expected to be hit.

However, FRA payments can be contractually modified, allowing market participants to get exposures similar to those from the original product.

“For FRAs there is a workable mathematical solution,” says the strategist at the second European bank. “Where we don’t really have a solution from our discussions is in Libor-in-arrears – that’s definitely been something that has been raised as a product that has definitely no solution.”

Some dealers say in-arrears swaps are not a widely traded derivative, so the impact of its discontinuation as a product is likely to be small. But others say the case of Libor-in-arrears swaps suggests industry discussions around Libor fallbacks have been too focused on plain-vanilla interest rate swaps.

“There aren’t that many counterparties that trade Libor-in-arrears, but this highlights issues with the transition that will need to be addressed,” argues the rates strategist at the second European bank. ”The focus on just plain-vanilla swaps ignores transition issues with the broader swathe of complex products linked to Libor that are currently traded in the markets.”

Editing by Lukas Becker and Olesya Dmitracova

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