• Matthias Degen, Partner |

LIBOR transition challenges: credit spread and new term structure

One challenge to preparing for the LIBOR phaseout is selecting the appropriate credit adjustment spread. Understanding the differences between IBORs and RFRs is essential and you’ll need to consider these aspects when adjusting client contracts or when assessing valuation impacts.

In this blog article, we dive further into some of the key differences between today’s Interbank Offered Rates (IBORs) and proposed new Alternative Risk-Free Rates (RFRs). Furthermore, we examine the advantages and disadvantages of the proposed RFRs.

As highlighted in our last blog, RFRs currently have no term structure and some of the proposed alternative RFRs (including SARON) are secured and as a consequence, unlike IBORs, do not bear a credit spread. These aspects will need to be considered when preparing for the transition, such as when adjusting client contracts or when assessing valuation impacts.

To address these issues, the International Swaps and Derivatives Association (ISDA) conducted a survey of 147 entities including banks, asset managers, insurers, pension funds and corporates. Market participants submitted responses on the proposed fallbacks for CHF LIBOR, GBP LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW. The ISDA’s findings were published in a final report on 20 December 2018.

Two key takeaways from the report:

  • Regarding to credit spread and term structure, a majority of respondents favored the “compounded setting in arrears rate term adjustment” combined with the “historical mean/median spread adjustment approach”.
  • ISDA plans to develop fallbacks for inclusion in its standard definitions based on the favored approach.

Advantages and disadvantages of the term structure construction

The favored term structure construction approach (compounded setting in arrears rate term adjustment) has advantages but also disadvantages.


  • It reflects actual daily interest rate movements during the relevant period.
  • It is calculated as an “average” rate and therefore should be less volatile than the spot overnight rate.
  • It should be understandable by most market participants.
  • It mirrors the structure of overnight index swaps referencing the RFRs.

Potential disadvantages:

  • Cash-flow uncertainty as the information needed to determine the rate is not available at the start of the relevant period.
  • The actual interest rate movements may not reflect prior expectations of interest rate movements over the period.

In the next few months, ISDA is expected to launch subsequent consultations on the final parameters of the historical mean/median approach and on covering benchmarks – which were excluded from the initial consultation (e.g. USD LIBOR).

Our recommendation

Firms should closely follow further developments to the ISDA fallbacks. Particularly, when considering whether or not to sign up to the ISDA protocol for legacy positions. The compounded setting in arrears rate term adjustment combined with the historical mean/median spread adjustment fallback approach is likely to cause economic transfer, in some cases, if the fallback is triggered. The economic transfer will be caused by the difference between the product and ISDA determined credit spreads.

Read press release: ISDA publishes 2018 Benchmarks Supplement Protocol

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