Libor Reforms

ICE Benchmark Administration (IBA), the new administrator of Libor has published a position paper on the future evolution of Libor. Following major reforms were proposed by the FSB on July 2014 for the major interest rate benchmark.

• Strengthening the existing IBORs and other potential reference rates based on unsecured bank funding costs by underpinning them to the greatest extent possible with transactions data (“IBOR+”)  
• Developing alternative, nearly risk-free reference rates (RFR) since FSB Members believe that certain financial transactions, including many derivatives transactions, are better suited to reference rates that are closer to risk-free.

Another concern was raised that reference rate should be based exclusively in actual transactions. But this can be applicable only  for the currencies or markets that have enough liquidity and actual transactions. When conditions in the local market do not allow pure transaction rates (ones derived mechanically from transacted data without use of expert judgement), authorities should work with and guide the private sector to promote rates which are derived on a waterfall of different data types: underlying market transactions first, then transactions in related markets, then committed quotes, and then indicative quotes.

IBA has proposed many reforms and it is expects the market participant's view by Dec 2014.Focus is on making the whole process including Libor definition , calculation methodologies used by individual banks, submitting Libor rates and selecting the final Libor rates, more objective and completely transparent.

I agree with Prof Jayanth that submitter should not do the interpolation for the missing points in the Libor calculation as this can be more efficiently done by the administrator.

Another important proposed change is to change the trimming of the top and bottom quartiles allows for the exclusion of outliers from the final calculation. This trimming methodology was benefited to counter manipulations. From this perspective, ‘topping and tailing’ may be less relevant in that it would adjust a rate that had already been calculated formulaically from observable and testable evidence. As mentioned in the position paper currently several alternatives of this approach are being evaluated. If this smoothing of submitted Libor rates gets hanged than it can have large impact on rate and on it's volatility.

Battle lines are drawn, among CCPs, who will win rates

A good read on this.

ISDA Stay protocol

The world’s biggest banks have agreed to rewrite  the rule book on derivatives contracts to make it easier to resolve a future failing institution like Lehman Brothers. ISDA announced that eighteen major global banks or G-18 have agreed to sign the ISDA stay protocol. The Resolution Stay Protocol is a major component of a regulatory and industry initiative to  address the too-big-to-fail issue by improving the effectiveness of cross-border resolution actions against a big bank – therefore ensuring taxpayer money is never again needed to prop up a failing institution. 

“This is a major industry initiative to address the too-big-to-fail issue and reduce systemic risk, while also incorporating important creditor safeguards. The ISDA Resolution Stay Protocol has been developed in close coordination with regulators to facilitate cross-border resolution efforts and reduce the risk of a disorderly unwind of derivatives portfolios,” said Scott O’Malia, ISDA Chief Executive.

Credit support annex of ISDA contracts governs the ~$700 trillion OTC derivatives market. In these type of ISDA contracts banks or firms have the right of termination of trade and seize the collateral when the counterparty fails. Banks or firms exercise this option to minimise the counterparty risk. According to report  from GAO office,Eighty percent of Lehman's derivative counterparties closed their deals with the bank with in five weeks of bankruptcy filing.  

Regulators had expressed concern that the simultaneous close-out of derivatives 
transactions during the resolution of a large, cross-border bank could hamper resolution efforts and destabilise markets.This is being addressed in certain countries through the development of statutory resolution regimes – for instance, Title II of the Dodd-Frank Act and the EU Ban Recovery and Resolution Directive – which impose a stay on termination rights in the event a bank is subject to resolution action in its jurisdiction. But regulators have realised that this can't be effective for cross border trades. 

The orderly liquidation authority (OLA) contained in the Dodd-Frank Act in the US, and the EU's Bank Recovery and Resolution Directive (BRRD) are two examples of so-called special resolution regimes, which allow authorities to take control of a stricken institution, restructure and recapitalise it, in the space of a day or two. These regimes include mandatory stays, but would only apply to a trade if both counterparties were subject to the law. In cross-border trades, that is unlikely to be the case. Hence becomes important that banks themselves give up  their rights to close the deals in case of counterparty fails. 

Some of the issues are still not clear as whether other market participants like asset management firms will follow the suite.Buy side firms can't voluntarily give up their rights because of fiduciary responsibilities to their clients. This further adds complications, major global banks will adhere to the stay protocol from Jan 2015 while other market participant will not adhere to it. Some market participants such as buy side firms will continue have the rights of terminating deals while banks no more can do it. This can create unbalanced scenario for the dealers or major banks.

Another more awkward issue is capital issue. Opinions are split on whether this will impacts the margin period of risk (MOPR) or not.The MPOR represents the length of time regulators believe it would take a bank to exit a portfolio of trades with a defaulting counterparty - the longer the MPOR, the longer the surviving dealer's exposure can grow.

How fruitful this protocol will be in future can be known in future. However working group members believe the document they ultimately produce will make the global financial system more resilient.

Growth of shadow banking

A good read on Growth of shadow banking from IMF blog.