- The recent announcement of LIBOR cessation dates provides investors some much-needed clarity on the process of transitioning away from LIBOR and falling back on replacement benchmark interest rates.
- While swaps linked to LIBOR and overnight rates are now tightly connected in their market prices, explicitly incorporating fallback provisions into modeling approaches may significantly alter risk assessments of LIBOR instruments.
- We used stress tests to quantify the impact of fallback provisions on the assessed risks of LIBOR swaps and highlighted the implications for risk management.
On March 5 the U.K. Financial Conduct Authority (FCA) confirmed the dates for LIBOR cessation and provided clarity on how fallback rates will be calculated for instruments that follow the fallback provisions set by the International Swaps and Derivatives Association (ISDA).1 We used stress tests to demonstrate that modeling for fallbacks could have a significant impact on risk estimates and to show that accounting for fallbacks may be necessary to effectively manage the risks of LIBOR instruments.
With LIBOR’s Days Numbered, Fallback Provisions Come into Play
The FCA confirmed that most LIBOR rates will cease to exist in their current form at the end of 2021.2 The announcement has significant implications for financial instruments that reference LIBOR after the cessation dates. For derivatives such as swaps, ISDA has put in place a protocol to determine appropriate fallback rates, defined as reference rates that will replace LIBOR once it is no longer available. For instruments that follow the protocol, fallback rates will be calculated as a compounded average of overnight risk-free rates, plus an adjustment spread that was fixed on March 5.3
LIBOR and Overnight-Indexed Swap Markets Have Converged
As a result of fallback provisions, most LIBOR interest-rate swaps are expected to turn into swaps referencing overnight rates after the LIBOR cessation dates.4 The exhibit below compares LIBOR- and overnight-rate-based swaps in different currencies, by calculating an implied spread over overnight reference rates that would make the swap value equivalent to a LIBOR-referenced swap. The convergence of this implied spread and the ISDA spread (fixed on March 5) confirms that LIBOR swaps are now tightly linked to overnight-rate swaps through the ISDA fallback spread.
Market-Implied Spread Converged with ISDA Spread
The ISDA fallback spreads are calculated and published by Bloomberg Index Services Ltd. For CHF, GBP and JPY, the spreads are shown for 6-month LIBOR, while for USD, the spreads are presented for 3-month LIBOR.
Fallbacks Altered Risk Assessments
For portfolios of instruments linked to LIBOR, another consequence of the ISDA fallback protocol is that some LIBOR exposure is now replaced by exposure to overnight risk-free rates. The interactive exhibit below shows the effect of a 10-basis-point (bp) change in different interest rates on LIBOR swaps modeled with and without incorporating the fallback protocol. Depending on the modeling approach, there may be significant differences in sensitivities. This underscores the importance of incorporating LIBOR fallback provisions in order to correctly measure and attribute risk.5
Sensitivity of LIBOR Swaps to Interest Rates with and Without Fallback Modeling
The chart shows the change in value (as a percent of notional) for a 10-basis-point change in interest rates for a spot starting payer LIBOR swap. When “Overnight Rate” or “LIBOR” sensitivity is selected, only the corresponding interest-rate curve is shifted. When “Total” is selected, both interest-rate curves are shifted. When modeling fallbacks, the ISDA protocol is followed. Discounting of cash flows is based on the overnight risk-free curve in all cases.
Implications for Risk Managers
Using historical data as a basis for risk assessments is common in risk management and may help correctly capture movements of those factors to which the instruments are exposed. To further illustrate the importance of modeling the fallback behavior, we applied a stress test that moves rate risk factors in line with the market movements that took place between Feb. 19 and March 9, 2020 — i.e., during the onset of the COVID-19 crisis. The exhibit below compares the impact of the stress test with and without considering fallbacks for payer LIBOR swaps across different maturities and currencies.6 The value changes are shown as a percentage of notional value.
Stress-Test Results with and Without Fallback Modeling
During the period considered, both LIBOR and risk-free interest rates decreased. The magnitude of the decreases differed, however. For example, in the case of GBP-denominated swaps, the 10-year LIBOR swap rate decreased by 31 bps, while the 10-year overnight-indexed swap rate decreased by 39 bps. As a result, GBP swaps lose more value in our stress test when fallbacks are considered. Note that LIBOR has a credit-risk component that risk-free rates do not — which may have contributed to the observed differences in market movements.
As the final days of LIBOR approach, incorporating fallback provisions in models may have significant implications for managing the risks of existing LIBOR-linked instruments.
1“Announcements on the end of LIBOR.” Financial Conduct Authority, March 5, 2021.
“ISDA 2020 IBOR Fallbacks Protocol.” International Swaps and Derivatives Association, Oct. 23, 2020.
2Stafford, P. “Libor to cease for most currencies by end of 2021.” Financial Times, March 5, 2021. Several USD LIBOR tenors will continue to be published until June 30, 2023.
3The adjustment spreads are calculated and published by Bloomberg Index Services Ltd. using ISDA methodology. The spread varies by LIBOR currency and tenor. For USD-denominated instruments, the fallback calculations are based on the secured overnight financing rate (SOFR), a rate benchmark that measures the cost of borrowing overnight secured against U.S. Treasury securities. Other overnight risk-free rates are the sterling overnight interbank average (SONIA) in the case of the British pound, Swiss average rate overnight (SARON) for the Swiss franc, euro short-term rate (ESTR) for the euro and Tokyo overnight average (TONA) for the yen.
4Interest-rate swaps are the most heavily traded LIBOR derivative instruments.
5While the total rate-change impact is similar, swaps valued without considering fallbacks are exposed to the overnight rate only through discounting. In contrast, for swaps modeled with fallbacks, overnight rates determine floating-rate cash flows for payment dates after LIBOR cessation.
6Payer interest-rate swaps pay fixed coupons and receive floating coupons. When rates rise, the value of such swaps tends to increase.