IBOR transition: implications of COVID-19 on spread adjustments from a conduct risk perspective by Maximilian Beckmann, Stefan Wingenbach, Peter Woeste Christensen spread adjustments under the isda fallback approach ISDA has played the central role in developing the framework to end LIBOR. A long and transparent process has resulted in a seemingly simple approach. The LIBOR benchmark will be replaced by an Adjusted Reference Rate (ARR) plus a fixed Spread Adjustment. Usually, the ARR is the compounded risk-free rate (RFR). The spread adjustment reflects a compensation for risk premiums embedded in LIBOR compared to a risk-free rate. The spread adjustment is fixed by ISDA and Bloomberg on the day the cessation is triggered by either the benchmark administrator or another competent authority. The fixing of the spread adjustment relies on past fixings only. No market data or other forward-looking information is used in the determination. Market participants with LIBOR exposure maturing after 2021 are all exposed to the fixing of the spread adjustment. COVID-19 triggered market uncertainty has caused a sharp increase in the risk premiums embedded in LIBOR. Banks now have the following challenge: what is the right transition approach and how to advise clients on it during the course of the transition?
ISDA approach: details of the methodology The fallback approach embedded in the 2006 ISDA Definitions has three central aspects. 1. Adjusted Reference Rate: Which rate will replace LIBOR? 2. IBOR Cessation Trigger Date: When is the Spread Adjustment fixed? 3. Spread Adjustment: How is the Spread Adjustment calculated? The Adjusted Reference Rate (‘which rate’) was determined by ISDA in 2019 and for each LIBOR it represents the RFR in the respective currency. The timing (‘when’) is determined by the so-called trigger event. This is either a ‘cessation announcement’ or a ‘non-representative’ determination of the benchmark. The spread adjustment between LIBOR and the adjusted reference rate is calculated and fixed as of the IBOR cessation trigger date. In July 2019, ISDA announced that Bloomberg Index Services Limited (BISL) would be the adjustment service vendor to calculate and publish spread adjustments related to fallbacks under the 2006 ISDA definition. 040
Intelligent Risk - July 2020
