On 6/30/23 Changes in $200 Trillion of Derivatives Risk the Financial System While The Elite Write Their Own Terms
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Photo Credit: L & K Bespoke Tailors
By Stan Szymanski
On June 30, 2023 the financial world changes. On that date all derivatives and credit contracts that were based on the LIBOR (London Interbank Offer Rate) that have not already switched, will begin using the SOFR (Secured Overnight Financing Rate) as the new standard rate on which to base financial contracts upon. The risks to the financial system can be summarized thusly:
…’Transitioning to a new benchmark rate is difficult, as there are trillions of dollars worth of LIBOR-based contracts outstanding and some of these are not set to mature until the LIBOR’s retirement. That includes the widely used three-month U.S. dollar LIBOR, which has approximately $200 trillion of debt and contracts tied to it.’… (Secured Overnight Financing Rate (SOFR) Definition and History). According to a May 2023 Board of Governors of the Federal Reserve System Report…’many older contracts only have fallbacks appropriate for a temporary outage of LIBOR rather than its permanent cessation, and some contracts do not have any fallbacks at all.’…
So long story short, the transition of all dollar based derivative and credit contracts from LIBOR to SOFR involves at a minimum, hundreds of Trillions of Dollars of arrangements that will be trying to find some sort of market value on and after June 30, 2023. There is no firm tried and true pathway of conversion of valuation regarding the aforementioned massive quantity of financial instruments which will happen roughly at the same time. This, IMHO, will pose a significant risk to the viability of the western financial system. Only a few weeks after the cessation of the publication of LIBOR (12/31/21) and coinciding with the start of the Ukrainian war one can see the stair step higher of the ‘Risk Free Rate (SOFR). In my opinion, this rise in rates highlights the increase in risk and also is an attempt by market forces (and the powers that be: Fed/US Treasury/ International bodies) to find a more realistic ‘cost of money’ in the opaque world of derivatives where we will see-the elite write their own rules.
What is a Derivative?
…’The term derivative refers to a type of financial contract whose value is dependent on an underlying asset, group of assets, or benchmark. A derivative is set between two or more parties that can trade on an exchange or over-the-counter (OTC).’…(Investopedia)
So because of the transition from the use of LIBOR to SOFR the derivatives that are of particular interest at this time are the ones that are dollar denominated.
According to JP Morgan:
…’Regulators around the globe have developed more robust and transaction-based risk-free rates (RFRs) that are compliant with IOSCO financial benchmark standards for almost $400 trillion of wholesale and consumer products. ’…
These ‘Risk-free Rates’ (RFR) are supposed to be more ‘real world’ because they are based on transactions instead of being set by 16 international member banks as LIBOR was (is).
What is recognized as a ‘Risk-Free Rate (RFR)?
…’The risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time. …’In practice, the risk-free rate of return does not truly exist, as every investment carries at least a small amount of risk.’…’If you are finding a proxy for the risk-free rate of return, you must consider the investor's home market.’… ‘Different countries and economic zones use different benchmarks as their risk-free rate. The interest rate on a three-month U.S. Treasury bill (T-bill) is often used as the risk-free rate for U.S.-based investors.(Investopedia)
SOFR, representing loans backed by Treasury bonds (T-bonds), (Bills, Notes and Bonds posted as collateral in the Treasury Repo market-this note added) is a virtually risk-free rate. (SOFR Definition and History)
On March 27, 2023 the ISDA posted an article to its website entitled ‘The Final LIBOR Hurdle’ by ISDA Chief Executive Officer Scott O'Malia. In the article, Mr. O’Malia makes an interesting and salient point:
…’the volume of US dollar LIBOR derivatives far exceeds the amount linked to the other LIBOR currencies. While firms now have a tried-and-tested playbook, it means there is an extra level of complexity associated with this transition that requires close attention.’…
So the ‘US Dollar LIBOR derivatives far exceeds the amount linked to the other LIBOR currencies’. This means that the act of conversion of the US Dollar LIBOR derivatives from LIBOR to SOFR will have the biggest impact to the markets.
The ISDA also published an ‘IBOR Fallback Rate Adjustment Rule Book’-A 25 page pdf that describes the machinations of calculating the ‘spread’. The spread (Fallback Rate Adjustment) is the variable amount of payout that allows for uncertainty over and above the RFR (Risk Free Rate). In addition to the profound calculations found within the document, I found that according to the ISDA, that on a day that the most is happening (the occurrence of a ‘Market Disruption Event’) that day will not be considered a ‘business day’:
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Section 5. General Rules
5.1 Consequences of a Market Disruption Event
…’If, on any day, a Market Disruption Event occurs or is occurring, the Adjustment Services Vendor shall treat the day(s) upon which the value(s) of any Underlying Rate, or any other price or necessary information for purposes of calculating the Rate Adjustment is unavailable or during which it is otherwise unable to perform the requisite calculations, as not constituting a Business Day(s).‘…(IBOR Fallback Rate Adjustment Rule Book)
I am not a math wiz by any means. However, I have a hunch that if a big enough ‘Market Disruption Event’ occurs during the application of these rules, it would be enough to shut down or destroy the derivatives markets. Otherwise, why wouldn’t they call it a business day? If they can get away with not calling a business day like say, October 19, 1987 was a business day-well then we would have never had a market crash of 22% in one day.
Why didn’t Alan Greenspan think of just calling 10/19/1987 ‘not a business day’? Then, he wouldn’t have had to inject all that money into the system to keep it going! I’m glad that the people running things today have so much more common sense (sarcasm off).
If the holders of derivatives contracts didn’t have the option of invoking ‘not a business day’ and had to perform the calculation for the ‘spread’ and the spread did not cover the difference then, in my view, the derivative contract fails.
If you think that the elite who trade ‘not cleared’ derivatives (trades that are just between two parties and they like it that way) can only get creative with their workweek-think again!
In 2020 the ISDA (International Swaps and Derivatives Association, Inc) Issued a document: ISDA 2020 IBOR Fallbacks Protocol (IBOR Fallbacks Protocol) FAQs that offered ‘guidance’ to many questions when it comes to the use of the RFR and the additional spreads as it pertains to the conversion of derivatives contracts use of LIBOR to SOFR in their documents and the real world implications of such. Unbelievably, ‘parties can bilaterally agree to preserve bespoke provisions (emphasis added) in their Protocol Covered Documents’:
…’As explained in Question 12 (Can parties agree bilaterally to amend the terms or scope of the IBOR Fallbacks Protocol?), parties can bilaterally agree to preserve bespoke provisions in their Protocol Covered Documents that would otherwise be amended pursuant to the IBOR Fallbacks Protocol. Parties should carefully consider whether the IBOR Fallbacks Protocol will override or otherwise amend bespoke provisions in their Protocol Covered Documents and seek advice from professional advisors as required.’…(ISDA 2020 IBOR Fallbacks Protocol (IBOR Fallbacks Protocol) FAQs)
So in the end-after all of the steps to try to maintain order as the world precariously makes the shift from LIBOR to SOFR in the 400 Trillion (or do I mean Quintillion) dollar derivatives market, the elite, the ‘Powers That Be’-The ‘Masters of the Universe’ can and will do what they have always done…WHATEVER THE HELL THEY WANT TO!
Many traders and pundits today think that rates in the short end of the US Treasury market have gone up because there is an increasing rate of default of the United States debt. There is some truth to that especially in light of a recent U. S. CDS (Credit Default Swap) print of about 160-about where it was when Lehman went down in 2008.
But if that is the case, why are the rates on the 10 year and 30 year bond not going -substantially higher (and prices lower)- when the market starts believing en masse that the governments won’t be able to pay its bills? Who would put a bid under that bond?
Is the Federal Reserve really using its moral suasion to ‘fight inflation’ and push the Fed Funds Rate above 5%? In reality is it possible that the Fed is not pushing short rates higher to fight and extinguish inflation but is pricing a bigger return, a higher interest for the ‘Risk Free Rate’ portion of the to those settling derivatives trades?
Remember that …’the volume of US dollar LIBOR derivatives far exceeds the amount linked to the other LIBOR currencies’…A ‘risk-free’ interest rate of 5% of US T bills is anything but ‘risk free’ and where almost no other (I believe there may be one) county’s RFR has gone up in a graduated fashion such as the US since the beginning of the Ukrainian war and just 7 weeks after the cessation of derivatives contracts issued with any mention of LIBOR: ycharts
The ‘Risk-Free Rate (SOFR)’ plus the ‘spread (the ISDA Fallbacks protocol)’ is really just a ‘best guess’ at fudging the real value of derivatives contracts.
I believe it is quite possible that short term US rates are high because they, as the ‘Risk-Free Rate’, compensate the massive derivatives market for the new risks they are taking in the conversion of their contracts from LIBOR to SOFR. Especially considering that the IBOR Fallback Rate Adjustment Rule Book allows they system to take a day off (‘not constituting a business day’) in the event of a ‘Market Disruption Event’ (a default, a nuclear event, declaration of war, market crash, etc…). I think that it may even be possible that a market day outside of a standard deviation of their amazing calculations might be enough to invoke a ‘not constituting a business day’ provision for them to try to save their hind ends.
The elite change the rules (LIBOR to SOFR), give themselves the right to rewrite history (not constituting a business day) and the ability to maintain their ‘bespoke’ provisions (after changing the rules) with their partners in skullduggery-whomever has the other side of their trade.
We know that basically, all markets are rigged. But when they actually start to write it down, we can be pretty sure that they have -completely- lost their minds as they lose the rest of the world (and their influence) to the BRICS nations. The ‘Masters of the Universe’ are backed into a corner and trying not to lose their collective shirt.
Watch out for the next weekday that is ruled as ‘not constituting a business day’.
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Stan Szymanski (or Encouraging Angels) is not a medical doctor. This is not medical advice. In all matters pertaining to the health and care of a human being consult a medical doctor. This is not legal, financial or personal advice. Consult appropriate professionals in those fields for that type of advice.