Making Sense of The ISDAfix Swap Rate Suit

ISDAfix Swap Rate Manipulation - Q&A

So, what’s the Lawsuit all About and Why is Our Cat so Annoyed?

13 banks are being sued by Alaska Electrical Pension Board (AEPB) over ISDAfix Swap Rate Manipulation.

The banks named are Bank of America, Barlclays, BNP Paribas, Citibank, Credit Suisse, Deutschebank, Goldman Sachs, Royal Bank of Scotland, J.P. Morgan, Chase Bank, Nomura Group, HSBC, UBS & Well Fargo & Co, Inc.

Also named – and in bold print is ICAP, PLC the interdealer broker who was responsible for collecting the benchmark rates from the panel banks.

As for the cat (sigh) who knows.  Maybe it’s that his name is Swap and he thinks it’s demeaning.  But come on….is this the same cat who steals Grilled Chicken right off the sideboard?  Hypocritical much?   I knew we should have gotten a dog!

ISDAfix Benchmark Swap Rates versus LIBOR Reset Rates

To delineate LIBOR reset rates and ISDAfix swap rates1, here’s a quick compare and contrast.  There are also several blogs on the LIBOR crisis on this site  here and here.

ISDAfix & LIBOR reset rates are different in the following ways:

LIBOR Reset Rates with maturities from overnight to 36 months were submitted by panel banks to BBA at 5:00AM New York Time.  LIBOR deposit rates are unsecured loans made between banks.

ISDAfix Swaps rates with maturities from 2 years to 30 years were submitted by 13 banks to ICAP (an interdealer broker) at 11:00AM New York Time.   ISDAfix refers to the fixed rate on an interest rate swap where a Counterparty Pays (receives) Fixed & Receives (pays) LIBOR.  There is no principal amount, but rather a notional amount upon which all cash flows are calculated.

ISDAfix & LIBOR reset rates are similar in the following ways:

LIBOR Reset Rates are benchmark rates.  LIBOR Reset Rates are used to fixed the floating leg of interest rate swaps resetting that day as well as to reset Floating rate loans resetting that day.

ISDAfix Swaps Rates are also benchmark rates.  ISDAfix Swap rates are used by roughly 6,000 corporate treasurers and lenders to determine borrowing costs as well as value embedded options (swaptions).

ISDAfix Benchmark Swap Rates Subject of Lawsuit

What exactly are the ISDAfix Benchmark Swap Rates used for?

ISDAfix Swap Rates are used by Corporate Treasurers and Asset Managers to value swaps and estimate funding costs.

ISDAfix are used to value swaptions,

ISDAfix Swap Rates are tied to commercial and residential real estate securities.

How much of the mark is Impacted by ISDAfix?

As of July 26, 2014 DTCC’s stats show ISDAfix used for the following:

$29.5 trillion: Derivatives underlying swaption contracts outstanding

$550 billion: Securities tied to Commercial Real Estate

Fluctuation also determine the performance of structured notes

ISDAfix Manipulation

The manipulation themselves seem surprisingly simplistic.  Each business day (before 11:00AM NY Time) ICAP would call their submitting banks and provide an ISDAfix rate.  If the submitting bank agreed, their name was added to the list of institutions supporting that rate.  If the submitting bank felt ISDAfix should be a different rate, that rate was given the ICAP.

That would seem egregious enough, but with an escape clause.  But against the backdrop that ISDAfix rates were identical 90% of the time, out to five decimal places.  Once the investigation began in December 2012, ISDAfix rates were identical only 70% of the time.

A Closer Look at ISDAfix & Swaptions

To take a closer look at the impact of ISDAfix on Swaption values:

Payer Swaption: Holder has the right but not the obligation to enter into a swap to Pay fixed and Receive LIBOR at the strike rate on expiration date.  The buyer of the swaption pays a premium.  The seller receives that premium.  In return for receiving the premium, the seller takes on the obligation to Receive fixed and Pay LIBOR at the strike rate if the option holder exercises.  The payer swaption will be exercised if the swap rate is HIGHER THAN the strike rate on expiration day.

Receiver Swaption: Holder has the right but not the obligation to enter into a swap to Receive fixed and Pay LIBOR at the strike rate on expiration date.  The buyer of the swaption pays a premium.  The seller receives the premium.  In return for receiving the premium, the seller takes on the obligation to Pay fixed and receive LIBOR at the strike rate if the option holder exercises.  The receiver swaption will be exercised if the swap rate is LOWER THAN the strike rate on expiration day.

ISDAfix Manipulation: Impact on Cash Settled Swaptions:

There are many users of swaptions who, instead of choosing to exercise (be assigned) into an interest rate swap can choose to receive cash.  The cash amount will be the different of the swap rate on expiration date (the ISDAfix Swap Rate) versus the strike rate.

EXAMPLE:

Client is long a 1 year Receiver into a 10 year swap, strike rate is 3%. On expiration date the 10 yr swap rate is set by ISDAfix at 2.50%.  Table 1 shows the impact on the entire market ($29.5 trillion notional amount).

Table 1 shows the result if ISDAfix Swap rates were benchmarked 1 bps lower for all maturities out to 10 yrs, the impact on swaption values ($29.5 trillion notional amount) would be ~$700million.

13 Banks sued by AEPB over ISDAfix Manipulation

In reality, ISDAfix Swap Rates being set capriciously had a much larger overall impact on the market.  I show this Swaption illustration to define an approximate DV01 on this one area.

Changes Made to ISDAfix Benchmark, 2014

The following changes were mdae in 2013:

Clarification of ISDAfix now emphasizes that contributing banks use executable bid/offer rates

Suspension of ISDAfix maturities or currencies with insufficient liquidity in the underlying swap market

Stronger checks on Submission rates for validation

“Stronger checks” seems a bit ambiguous and this blogger hopes the language is strengthened to afford market participants great confidence as to the course and criteria for these all-important benchmark rates.

 

Our Cat, Swap/Puffy

Our sweet kitten “Swap” has demanded a name change.  He no longer wants to be affiliated with derivatives  in any way.   While I applaud his ethical stance,  he doesn’t mind the food it buys him.  Lest he think he won the war, we changed his name to  “Puffy”.  And yes, I’m grinning at the thought of my niece putting pink ribbons on him.

UPDATE:  Cute little Tabby Formerly Known As  Swap, requested name change in September 2014.  We named him Puffy.  Being tired of the jokes about his kitten name, he has decided Swap isn’t such a bad name after all.

 

FOOTNOTE:

1 for purposes of simplicity, this blog deals with the impact on US Dollar rates.

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