If you are following the news it may appear prudent to consider preparing for the end of Libor by 2021. The process of preparing will undoubtedly mean facing increased model complexity and associated costs to transition legacy systems that rely on Libor, but the transition to alternative benchmark rates will also expose the presence of new kinds of risk for investors.
This topic is covered in my recent contribution to Risk.net’s special report, “Beyond Libor,” where I discuss some of the impacts, both broad and technical, that we concluded from our analysis of the July consultation from ISDA. The documented Q&A is now available here.
New Risks Revealed
There are potential risks to be considered when Libor comes to an end, an event which is claimed to be on the horizon for 2021. When you consider how many derivatives and loans reference Libor today, any change to existing payout calculations could have huge effects on the markets. The end of Libor will basically throw the payout calculations in current trades into uncertain chaos, triggering fallback definitions that are still being debated, but which have the potential to impact the bottom line. Could these impacts depend on the market conditions at the time Libor is discontinued, such as where the spreads to other benchmarks lie on the day Libor ends? These are new kinds of market risk to consider, centered around the singular event of Libor’s demise that is slated for the near future.
Fallback definitions only help counterparties agree on how to calculate payments, but not in how to value trades. The current crop of alternative benchmark rates are unlike Libor, since they are overnight rates based on a different frequency of transactions than the payments of most interest rate swaps – this means pricing a swap that directly replaces Libor with overnight rates will need convexity adjustment, which requires modeling the volatility of the new interest rate benchmarks. The resulting prices will depend on which volatility model is used. The outcome of this is a major potential for model risk even for vanillas. To avoid this and transition smoothly in 2021, the fallback definitions, pricing models, and derivatives markets as a whole will need to evolve closely together.
The Impact on Models
In another topic discussed in the Risk.net Q&A - what I believe the impact will be on pricing models - I explained that there could be a veritable tsunami of problems when trying to remove Libor and Libor-linked trades as modeling inputs. Without Libor curves, we will have far fewer curves available to a market which has been multi-curve for a decade. However, modern investors cannot forget the embedded credit risk in term lending. This means it could eventually be necessary to use complex credit models, like CVA exposure modeling on a sector basis, in order to recover the equivalent multi-curve modeling that is currently standard practice. The Libor curve models in use today are popular, partly because it is easy to get approval and much faster to calculate than some kind of exotic CVA calculation based on simulation and credit volatility inputs. The jury is out for now, as it is currently uncertain if markets will continue to provide the term-lending rates that Libor provides today.
For the interest rate volatility needed for modeling, it is unclear where the market data will come from after Libor is gone. Currently the sources for interest rate volatilities are linked to Libor, such as swaptions on Libor. There will be a need for totally new markets on the alternative benchmark volatilities, in order to carry out derivative pricing—and the market makers must start clearing trades quoted by alternative benchmark volatilities. After Libor is gone, there will still be demand for volatility trades and the corresponding market data inputs to volatility models required by participants. However, it appears today that these markets simply don’t exist for the alternative benchmarks.
For more on this topic, view the special report, “Beyond Libor,” on Risk.net, and check out my related blog: Phasing out Libor brings Major Challenges to Risk Management.