Fallback dodgers walking a difficult path

Firms avoiding signing the Isda protocol will face challenges, say industry figures

With the cessation of US dollar Libor pushed back by 18 months, derivatives users may be tempted to delay the adoption of fallback language designed to smooth the transition to new benchmarks, or not sign them at all.

However, this week, senior industry figures said that would be a bad idea.

Speaking on Risk.net’s Libor telethon on December 8, Goldman Sachs’ Libor lead, Jason Granet, said signing the protocol was simply “good hygiene”. He pointed out that swap trades struck after January 25 will use the International Swaps and Derivatives Association’s new 2020 definitions, which include fallback language. If legacy positions remain without fallbacks, a basis will emerge between new and old positions. 

But the protocol, released on October 23, has so far seen tepid take-up. Only 1,791 firms had signed up as of December 9. That compares to the roughly 25,000 firms that signed up to Isda’s 2018 US resolution stay protocol, and some big names such as BlackRock are still missing.

Some argue that it’s better to ignore the protocol and try to negotiate fallbacks bilaterally, in an attempt to squeeze out better terms. That might make sense if a firm only has a handful of trades, but some argue it might actually be counterproductive. Speaking on the same Risk.net telethon, Prudential’s derivatives trading head, Chris McAlister, said dealers may be more amendable to negotiating a few troublesome trades if a firm has already taken the majority of the risk off the table via the protocol.

There’s also an element of self-protection in signing the protocol. “To the extent that you don’t sign and you end up in litigation, I imagine the first question will be ‘if everyone else signed it, why didn’t you?’,” McAlister said.

Another potential tactic is to not sign the protocol and hope legislation will take care of the problem. Legislation proposed in the US would provide another path to move some contracts referencing US dollar Libor to the secured overnight financing rate, or SOFR, but it’s unclear when this might arrive. 

In the UK, the FCA will be granted legislative powers to create new rates with the ‘Libor’ name that can be used in tough legacy contracts. But it’s unclear whether US dollar will be one of them, and regulators are unlikely to allow swaps to use them anyway.

A May 2020 tough legacy paper from the sterling risk-free rates working group noted that as derivatives have many routes to move off Libor, many will not be defined as tough legacy. But it also recognised that adoption of the protocol is voluntary, leaving open the possibility that some derivatives might sneak into the definition.

But that’s by no means certain. Goldman Sachs’ Granet said regulators should provide more clarity on what will be counted as tough legacy. Otherwise, derivatives users that opt to rely on tough legacy fixes may find themselves arguing the point in the courts.

That route could also incur the wrath of regulators: during a speech in August, the FCA’s market policy head Edwin Schooling Latter said UK-regulated firms with major derivatives exposures that do not sign up “will need to be ready for some serious questions from supervisors on how they will mitigate these risks”.

In any case, Schooling Latter said, the creation of these synthetic Libor rates may depend on strong levels of adoption of the Isda fallback protocol, as the regulator does not view the rate as a “suitable foundation for derivatives markets”.

With 2021 fast approaching, the buy side’s options appear to be shrinking.