This note explains a feature of the ISDA LIBOR fall back mechanism that may have a material impact on the value and risk profile of FRAs expiring after the end of 2021.
ISDA have proposed a fall back mechanism to determine how LIBOR indexed derivatives will behave in the event that LIBOR is discontinued. Full details of how the fall back will work are available here:
This fall back will be adopted unilaterally by clearing houses.
The fall back rate is based off compounded RFR over the underlying LIBOR term plus a spread adjustment. Unlike LIBOR which is a forward looking rate, the fall back is a backward looking rate and not known until the end of the underlying LIBOR term. Typically LIBOR derivatives have a natural lag of the tenor of the LIBOR after fixing date so the fall back rate will be known in time for payment. However for FRAs there is no lag between fixing date and payment date. So whilst the floating payment for a 3M GBP LIBOR swap which fixes on 12th August would be made on 12th November, the equivalent FRA would pay immediately.
The backward looking nature of the fall back rate presents a problem for FRAs who need to know the fall back rate on the original LIBOR fixing date in order to make their payment.
The ISDA procedures indicate that, in cases where the proper fall back rate is not available at the time of payment, the fall back rate published 2 business days prior to payment date should be used instead. So the GBP 3M LIBOR FRA fixing on 12th August would take the fall back rate published on 10th August. This fall back is based on SONIA fixings from 10th May to 10th August, 3 months earlier than the exposure of the original LIBOR fixing.
So for FRAs the fall back results in the underlying interest rate risk moving earlier in time by the tenor of the FRA.
It is possible, but far from certain, that clearing houses will deem this behaviour undesirable and decide to restructure affected FRAs into single period swaps.
Given the uncertainty we would caution against trading FRAs which fix after the end of 2021 when LIBOR publication is expected to cease.
Instead, we would suggest attaining the same risk exposure through a single period swap.