The ISDA protocol is a convenient, low-cost mechanism to update large volumes of bilateral documentation. However it does have the disadvantage of treating all products the same way.
The ISDA1 protocol is a convenient, low-cost mechanism to update large volumes of bilateral documentation. However it does have the disadvantage of treating all products the same way. The treatment of non-linear products specifically deserves a closer look.
In this note we quickly review the main non-linear products and outline what we think still needs to happen to ensure a vibrant and liquid market in the new reference rates. The Sterling RFR2 Non Linear Task Force is also wrestling with these points at the moment, and we are hopeful that they will publish some recommendations soon that the market can coalesce around.
The way the fallback protocol works is that once you adhere, you adhere for all legacy trades that reference an IBOR3 in a range of documents. If your counterparty also adheres, then the new fallback language is applied to all transactions between the two of you.
There is no opt-out for particular products or specific transactions. ISDA envisages that counterparties will subsequently enter into bilateral amendment agreements to exempt certain trades or products, or override their treatment with better alternative(s). See ISDA’s RFR Conventions and IBOR Fallbacks – Product Table for more information.
Caps / Floors
- Caps and floors will transition to options on a rate only fully known at the end of the period, unlike legacy caps where it is known at the beginning of the period, an effect known as “maturity extension”.
- The new (replacement) rate is a compounded rate, meaning options will essentially transition from being European to Asian for valuation purposes.
- A lack of lag between fixing and payment may be an issue for some of the smaller clients.
- The ISDA fallback transition, if not bilaterally re-negotiated, will result in a value transfer, primarily due to the maturity extension and Asian features.
- Legacy swaptions reference ICE swap rates that are LIBOR-based. There is a need for a transition formula for LIBOR swaps to SONIA4 swaps so physically-settled swaptions can continue to settle via the CCPs5
- A transition formula is also needed to produce synthetic LIBOR swaps fixing rates for cash-settled swaptions and any other CMS-linked6
- Note the ‘SONIA first’ conventions switch on 27 October is expected to drive greater interbank liquidity towards SONIA which in turn may help liquidity in the swaptions market.
Range accruals … in arrears / in advance
- The ISDA fallback language ensures that the product can still function technically, but its characteristics and valuation will be altered significantly. For example most if not all rates feeding the range accrual factor calculations will be the same rate (for the most standard variety of range accruals), being the compounded rate published just before the range accrual coupon payment date.
- Value transfer and issues with more complicated valuations are present here as well.
- It has been suggested that a better alternative could be to use term RFR rates as a replacement, such as a 1y CMS rate, but that can only be effected by bilateral agreement post-ISDA protocol adoption.
ICE Swap Rate
- Banks need to consult with ISDA on a new fall-back procedure when for some reason the RFR swaps fixing rate is not available. This is not really transition related, but acknowledging the fact that reference rates from a panel of other banks don’t work.
- In September the BoE wrote to ICE asking them to consider a SONIA-based methodology to provide a ‘synthetic’ GBP LIBOR ICE Swap Rate (ISR) for use in legacy trades only. ICE are already now publishing in beta testing mode a SONIA ISR.
To read a more in-depth study of some of the issues raised here please see the paper Interest Rates Benchmark Reform and Options Markets by our Head of Quantitative Analytics, Vladimir Piterbarg (free to access but requires registration).
The non-linear taskforce is working hard to find that ‘straight’ path forward but pressure is mounting with the market looking to sign-up over the next few months to a protocol that doesn’t carve out such products.
In the meantime, all eyes are on the ISDA website to see the pace of adoption of the protocol now it’s been launched.
International Swaps and Derivatives Association
Risk Free Reference Rates
Interbank Offered Rate
Sterling Overnight Index Average rate
Central counterparty clearing houses
Constant maturity swap