In the last few years, the projects that I have managed to work on, are really squiggly in nature. Last Christmas(2020), while the world was celebrating year end holidays, I was slogging away and writing code that would help a bank incorporate Risk free rates in to their products. It was exciting to be working on something where the big boys of the enterprise software were not flexible enough to support the new requirements. Also many aspects were yet evolving and hence there was a need to “figure” out what needs to be done, instead of coding something that was available as a spec. I had to write the spec taking in to consideration that not everything is black and white, and subsequently implement the spec. In any case, the project that I worked on, turned out to be a success and subsequently there have been interesting offshoots to the work that others have put in place. One of the offshoots is in the “Fallback” world. The basic idea of “fallback rates” is that the risk free rates are credit adjusted and made available to market participants, so that they can start changing the interest rate derivative contracts. The “fallback” as the name suggests creates a safety net in the contracts, while an active transition plan is put in place.

Stumbled on to a concise writeup by KPMG that talks about all the relevant aspects of this transition. This blogpost will list down some of the main points mentioned in the writeup

  • IBOR is calculated for 5 different currencies (USD, EUR, GBP, JPY, CHF) across 7 maturities(overnight, 1 Week, 1M, 2M, 3M, 6M and 1Y) - Total of 35 IBORs are published each day
  • In July 2017, FCA announces that, after 2021, it would no longer compel banks to make submissions to enable the calculation of LIBOR
  • In July 2018, FCA recommended that market participants move towards RFR
  • In Oct 2020, ISDA published fallback protocol
  • In March 2021, FCA announced cessation of 35 LIBOR benchmarks
  • Basic differences between LIBOR and RFR
LIBOR RFR
Non transactional Fully transactional based
Term structure exists Overnight tenor only
Unsecured Secured/Unsecured
Illiquid Highly liquid and deep
Easily manipulated Not easily manipulated as it is backed by actual transactions
Not transparent to market participants Transparent methodology
600M USD daily trading volume 2T daily trading volume
  • ARRs in major global markets
    • SOFR
    • SONIA
    • ESTR
    • SARON
    • TONAR
  • MIFOR : Synthetic benchmark with USD LIBOR and USD INR forward premia as the components
  • MIFOR based exposure across various financial contracts is 500B USD
  • For legacy contracts, the adjusted MIFOR would be another adjustment to the fall back rate(SOFR + spread adjustment). For new contracts, the modified MIFOR is to be used
  • ISDA methodology for fallback
    • Component 1 : Compounded RFR with 2 day business day back-shift(Consistent with OIS market)
    • Component 2 : Static Spread adjustment for counterparty risk based on 5 year look back period
  • Impact of transition will be felt on all areas of a bank
    • Treasury
    • Valuation under the new regime
    • Counterparty Credit risk management
    • Financial accounting and hedge accounting