Benchmark Transition Plans will be Critical

Last week saw the US Alternative Reference Rates Committee (ARRC) – a US public-private sector working group led by the Federal Reserve – select its choice for a risk-free rate that could be used as an alternative to US dollar LIBOR for certain derivatives and other contracts in the future. The next step is to think about how to encourage its use and to transition to the new rate – and that’s the really tricky part. Certainty will be critical: market participants will need a clear plan.

The ARRC isn’t the only public-private sector group to be going through this process. Similar initiatives to identify and transition to alternative risk-free rates are progressing in the UK and Japan – part of a broader project to enhance financial benchmarks, which also includes work by benchmark administrators to strengthen the methodology for existing IBOR rates and an initiative led by ISDA to identify robust fallbacks that would apply to IBOR-linked derivatives contracts should an IBOR rate permanently stop being published.

Together, the transition to risk-free rates and the development of IBOR fallbacks will affect trillions of dollars in notional in interest rate derivatives trades. So it’s important that people understand what these developments are and what they mean. It’s also vital that market participants can implement the changes in a way that creates most certainty and least disruption – both now and down the line.

The transition to risk-free rates is particularly challenging, because each case is unique – there’s unlikely to be a one-size-fits-all transition plan that suits all rates and all jurisdictions. Despite this, we think there are some high-level principles that can guide market adoption.

First, it’s critical that the alternative rate is sufficiently liquid to support its role as a key market benchmark. If not, the priority should be to encourage trading in the underlying rate first, before any benchmark transition occurs.

A liquid basis market to enable the hedging of basis risk between the existing interbank rate and the selected rate is also a necessary prerequisite before any transition occurs. As a third principle, formal public-private cooperation should continue (or begin in jurisdictions other than the US, UK and Japan) to ensure the transition is implemented as smoothly as possible. These transitions should allow sufficient time for market participants to make the necessary changes to systems, processes and documents.

It’s also important that authorities and industry participants try to anticipate the future shape of the market. There needs to be a clear understanding of what end users want to achieve and the risks they want to hedge to determine whether there will be a continuing demand for the old benchmark rates. End-user outreach will therefore be vital.

Finally, serious consideration must be given to whether the transitions should apply to legacy trades. Switching the reference rate for existing transactions would likely result in shifts in valuations, which could be disruptive to the market. As a result, we expect the public-private sector transition plans will target new trades only.

Last year, the ARRC proposed a paced transition plan that is largely consistent with these principles. It emphasizes the building of liquidity in the new rate before encouraging market participants to use it for trading. It also highlights the importance of building a market for hedging basis risk between the existing and new rate. Critically, it only refers to transitioning new contracts to the alternative rate, rather than forcing the transition of legacy contracts.

Another question is, what happens to existing and future IBOR contracts should the IBOR rate be permanently discontinued? That’s the focus of a separate ISDA-led working group. Together with the Financial Stability Board, the working group is looking to identify robust fallbacks for key IBORs that can be written into derivatives documents – likely to be the relevant risk-free rates chosen by the respective public-private sector working groups.

Unlike the work to transition to risk-free rates, which will likely focus on new contracts only, we think there’s a logic to identifying a robust fallback for all key IBOR contracts, both new and legacy. That’s because if a tail event occurs and an IBOR rate stops being published, it makes sense for everyone to be using the same, published fallback rate. Certainty regarding which rate to reference would be just as important for legacy contracts.

If that is indeed the case, then ISDA could publish a protocol to help firms alter their legacy contracts to incorporate the fallbacks in an efficient way. This would only work if everyone changes their contracts, though. If only part of the market makes the change to their legacy contracts, firms would face significant basis risk. As all ISDA protocols are voluntary, there would likely need to be regulatory action to ensure everyone makes the change.

This is just part of ISDA’s broader work on benchmarks. Along with being an observer on three public-sector risk-free rate working groups and leading the initiative to develop IBOR fallbacks, we’re also working with the industry to help prepare for compliance with the EU Benchmarks Regulation from the start of next year.

We’ll continue to focus on this area and will inform members and industry about forthcoming changes and implications. As part of that, we’ll shortly be holding a benchmark symposium in New York on July 12. We hope to see you there!

Time Ticking on Next Margin Deadlines

Time has a habit of marching relentlessly on, and revised compliance dates for counterparties to make changes to their collateral documents as part of new variation margin requirements are nearly upon us in some cases. Substantial progress has been made over the past few months because the industry isn’t being complacent – yet there’s still more to do, and little time to do it in.

ISDA has been tracking industry progress on a weekly basis since the beginning of the year. The data shows that more than three quarters of outstanding credit support annex (CSA) agreements have now been amended. That represents a big jump from the 30% just before the original variation margin ‘big bang’ implementation date of March 1 – which, in turn, represents thousands of hours of complex bilateral negotiations with counterparties to agree the changes. We have provided this information to regulators across the globe, and they are keenly interested in the progress that has been made.

But with the variation margin forbearance period set to end on September 1 in some jurisdictions, including the US, there’s little time left to make changes to the remaining 20-25% of CSAs. Along with the end of forbearance, other jurisdictions – Australia, Hong Kong, Switzerland and Singapore – are due to require compliance with their variation margin requirements from September 1.

Given the progress made over the past few months, it might seem like there’s time aplenty to complete the job. But the second phase of the initial margin requirements is also due to take effect on September 1 – which means that phase-one and phase-two banks will be finalizing their initial margin documents, and phase-two firms will be implementing the necessary systems changes. It should also be noted that the ISDA SIMM has been updated to include additional risk factors relating to cross-currency swaps, inflation swaptions and collateralized debt obligation tranches. ISDA SIMM 1.3 was undertaken at the request of the Federal Reserve Bank, and we’re also going through the annual recalibration process and the results will be shared with global regulators. All of this means there will be competing demands for limited resources during the coming summer months.

The scale and complexity of the variation margin repapering exercise has been immense. The March 1 deadline captured banks, asset managers, insurance companies and hedge funds across the US, European Union, Japan and Canada. While the vast majority of those entities already posted variation margin on their non-cleared derivatives, the rules required certain specific changes to be made to collateral documents in order to comply with the rules. ISDA estimates more than 150,000 CSAs needed to be amended – and all changes had to be negotiated and agreed by each pair of counterparties.

ISDA has been focused on helping firms with their compliance efforts, and published a protocol that offers a scalable option for amending multiple CSAs to comply with the variation margin requirements. That protocol remains open, and has been extended to include Australia, in addition to the US, Canada, European Union and Japan. We would urge firms to push ahead with their remaining negotiations, and aim to complete the work as soon as possible.

There is a potentially troubling aspect to this, though. There have been questions over whether regulators might require trades entered into from March 1 to be unwound if they are not subject to regulatory compliant variation margin CSAs by September 1. This action is both counterproductive to good risk management and impracticable, as firms lack a contractual mechanism to force their counterparties to unwind the transactions in those circumstances.

Even if achievable, such a requirement would be unlikely to reduce systemic risk in any meaningful way, given ISDA data that shows approximately 90% of relationships that are in-scope for the repapering exercise are already backed by variation margin, just not with the required changes to the underlying documentation to bring them into full alignment with the regulatory mandated terms. Planning a program to unwind transactions would divert key resources away from the main task of completing the variation margin repapering and implementing the phase-two initial margin changes.

Due to the conditions of the available regulatory forbearance, market participants have been careful to engage in activity that does not present significant credit and market risks. Indeed, some trades entered into from March 1 may offset the risks of transactions entered into prior to that date. Forcing firms to unwind trades would therefore lead to significant market disruption, could result in some entities being left unhedged, and would disadvantage firms in a subset of jurisdictions, which could lead to regulatory arbitrage. That’s surely contrary to the intention of regulators.

ISDA will continue to track the industry progress and keep global regulators informed of the overall number of CSAs that have been renegotiated and updated leading up September 1. We are also helping all phase-two banks prepare for the next round of initial margin exchange utilizing SIMM 1.3.