The Working Group on Sterling Risk-Free Reference Rates has published a market consultation on credit adjustment spread methodologies for fallbacks in cash products referencing GBP LIBOR to assist cash markets, including the syndicated lending market, consider methodologies for credit adjustment spreads for fallbacks from LIBOR to a SONIA-derived rate that operate from a trigger date on the cessation of LIBOR, or, before the cessation of LIBOR where triggered as a consequence of a regulatory announcement of non-representativeness of LIBOR. The consultation focuses on the methodologies identified for the derivatives market recognising that consistency in the loans market would minimise basis risk where derivatives are used to hedge interest rate risk and reduce operational, legal, tax, accounting and similar issues between loan products and related securitisations and hedges.
The consultation does not consider fallbacks triggered by contractually agreed early opt outs (for example when using one of the LMA’s recommended forms of revised replacement of screen rate triggers where in the opinion of the majority lenders and the borrowers, the screen rate is otherwise no longer appropriate for the purposes of calculating interest under the agreement), or new loans based on a SONIA-derived rate which will be the subject of further publications by the Working Group.
The consultation outlines four possible methodologies:
Option 1 – ISDA historical median approach
In this approach the credit adjustment spread will be based on the difference between GBP LIBOR and the SONIA-derived rate that is calculated using a median over a five-year lookback period prior to the fallback activation date based on the historical differences between GBP LIBOR and the SONIA-derived rate over a given period of time. This will produce a single value for the credit adjustment spread for each GBP LIBOR tenor based on historical differences between the GBP LIBOR for that tenor and the SONIA compounded rate over the relevant tenor.
Option 2 – ISDA forward approach
The credit adjustment spread could be calculated at the fallback trigger date based on observed market prices for the forward spread between GBP LIBOR and the SONIA-derived rate plus a spread based on a forward spread curve up to 30 – 60 years (which would specify the spread to be applied for every future date and would be frozen at the fallback trigger date). For future dates beyond the length of the curve, the spread would remain static at the spread for the last date on the curve.
Option 3 – ISDA spot-spread approach
The credit adjustment spread could be based on the spot-spread between GBP LIBOR and the SONIA-derived rate on the day preceding the fallback trigger date, or an averaged of the daily spot-spread between GBP LIBOR and the SONIA-derived rate over a specified number of trading days prior to the fallback trigger date. This approach is similar to the Option 1 historical median approach and derives a single value for the credit adjustment spread, but references a very short period. The credit adjustment spread would be calculated and published for each relevant GBP LIBOR tenor.
Option 4 – Modified forward approach
Similar to Option 2, the ISDA forward approach, the credit adjustment spread could be based on observed market levels for the forward GBP LIBOR / SONIA-derived rate spread in the relevant GBP LIBOR tenor but, in this case, restricting the number of spread values to five data points after the fallback trigger date (as opposed to each day into the future) and collecting data over a long observation period (1 year is proposed) and averaged.
The consultation outlines the possible concerns of using each method and invites comments from market participants by 6th February 2020 with the expectation that the feedback will assist the market in developing conventions on appropriate credit adjustment spread methodologies for cash products.