Industry mulls auction-based Libor swaps transition plan

Stanford’s Darrell Duffie proposes solution for switch to referencing alternative risk-free rates

Could an auction-based approach complement a synthetic Libor rate?

Industry groups are considering an auction-based approach to converting legacy Libor-linked swaps to reference new risk-free rates ahead of any discontinuation of the benchmark. It comes two months after one working group proposed using a synthetic Libor rate should the main swaps reference rate disappear.

The auction idea was recently sketched out by Darrell Duffie, professor of finance at Stanford University’s Graduate School of Business, at a Six Swiss Exchange-hosted event in Zurich. It was also mentioned in an August 3 research paper by Reiko Tokukatsu, a strategist at BNP Paribas in Tokyo. It is understood the idea has been shared with some regulators, an International Swaps and Derivatives Association working group and some risk-free rate working groups. The idea has early support from the co-head of the Swiss franc RFR group. 

“The auction approach sounds compelling to me,” says Martin Bardenhewer, head of financial institutions and multinationals at Zürcher Kantonalbank in Zurich, and co-chair of the Swiss franc working group. “It might be a bit complex, but only at first sight. I’m sure it will be discussed in the different groups in the forthcoming months.”

The Financial Stability Board has led a global push to move the swaps market off relying solely on Libor as a reference rate for swaps contracts, and to reference alternative RFRs instead. Meanwhile the UK’s Financial Conduct Authority said in July that it will stop compelling banks to submit to a range of Libor panels from the end of 2021. This has raised concerns the benchmark may cease after that date and created uncertainty for swaps users.

Under the plan, counterparties to Libor-linked swaps would amend their documentation to reference an RFR well before the benchmark might cease. Moving from Libor to an RFR would create a valuation change, given the RFR will probably be lower than the relevant Libor rate. The idea is to find the amount of compensation that each side will be willing to pay and receive to make the switch.

The auction approach sounds compelling to me… I’m sure it will be discussed in the different groups in the forthcoming months

Martin Bardenhewer, Zürcher Kantonalbank

To achieve this, a double auction could be held for wholesale market participants, potentially co-ordinated by a clearing house. Those receiving Libor on swaps contracts would bid what they think they should receive as compensation to change to the RFR. Those paying Libor, meanwhile, would bid the amount they would be willing to pay.

Participants in the auction would then be compensated at the determined stop-out rate, calculated by finding the point at which the quantity of bids to stop receiving Libor is equal to the quantity of bids to stop paying Libor. 

A protocol could be established to allow counterparties that did not participate in the auction process to automatically convert to the new RFR and use the compensation rate determined in the auction. Users of the protocol would pay a small fee to the winning bidders to encourage market participants to take part in the auction rather than sit on the sidelines.  

Synthetic fallback problems

The auction plan differs from the one proposed by an industry working group in recent months. The International Swaps and Derivatives Association has already confirmed it is willing to develop a protocol that would allow market participants to update existing documents to insert a fallback rate should Libor cease to be published after 2021, or possibly sooner in the case of Euribor. 

In a webinar on August 17, Isda announced a proposal, developed by one of its working groups, for that fallback rate to consist of the RFR plus a spread based on a snapshot of the Libor-RFR basis on the day the benchmark ceased. The spread on top of the RFR would be frozen from that point, making it in essence a synthetic Libor rate. 

But it is unclear how this would work in practice, says Duffie. He suggests it would not be possible to take a snapshot of the spread of 30-year Libor and an RFR, for example, until a matching term structure has been developed.  

Darrell Duffie: auction proposal is still a rough concept

“If you just say next Wednesday we’ll take whatever the spread implied by the market is and we’ll use that for conversion purposes, then there is a problem,” says Duffie. “The new RFR term structure of interest rates is not clearly defined yet and probably won’t be in time before conversion to Libor starts to become problematic. So you wouldn’t have a good market for determining what a fair conversion rate is.”

Even if some swaps users were prepared to accept whatever conversion rate is determined by the basis spread, other market participants could attempt to nudge the rate to their advantage in the run-up to the protocol, he adds. 

Taking an average over a period to reduce the possibility of manipulation could be problematic if the term structure shifts during that window, Duffie says. However, he concedes that his idea remains a rough concept at this stage and the minutiae of how such an auction would be organised would need to be thrashed out by the industry.  

Isda says it is aware of the proposed auction plan and that it is currently being discussed by its working group, but declines to comment further. Zürcher Kantonalbank’s Bardenhewer, meanwhile, believes an auction could complement – rather than supplant – the synthetic approach.

“It could complement approaches based on financial engineering techniques which calculated spreads out of historical data with forward-looking market-based information,” he says. “For example, first an auction could be held to clear as much contracts as possible; then the realised outcome of the auctions could be compared with the theoretical outcome of the approaches discussed in the Isda working groups.”

 

Update, October 11: This story has been updated to add that Reiko Tokukatsu, a strategist at BNP Paribas in Tokyo, had also suggested the auction idea in a research paper published on August 3.