24 Sep The ISDAFIX Swap Rate Lawsuit
So, what’s the Lawsuit All About and Why is Our Cat So Annoyed?
I got home from a long day at work only to find my cat, swapper giving me the side eye. It took me a while to figure out why he was so annoyed. I saw the newspaper and right there, he showed me EXACTLY what he was so annoyed about.
13 banks are being sued by Alaska Electrical Pension Board (AEPB) over ISDAfix Swap Rate Manipulation.
The banks named are Bank of America, Barclays, BNP Paribas, Citibank, Credit Suisse, Deutsche Bank, Goldman Sachs, Royal Bank of Scotland, JPMorgan, Chase Bank, Nomura Group, HSBC, UBS and Wells Fargo & Co, Inc. Also named: 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 Swapper 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
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 5:00 AM 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 11:00 AM 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 is used to value swaptions.
- ISDAfix Swap Rates are tied to commercial and residential real estate securities.
- How Much of the Market 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 determines the performance of structured notes
The manipulation itself seems surprisingly simplistic. Each business day (before 11:00 AM 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 the 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 the 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 difference of the swap rate on the expiration date (the ISDAfix Swap Rate) versus the strike rate.
The client is long a 1-year Receiver into a 10-year swap, strike rate is 3%. On the expiration date, the 10-year swap rate is set by ISDAfix at 2.50%. Table 1 shows the impact on the entire market ($29.5 trillion notional amount).
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 made 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, SWAPPER/FLUFFY
Our sweet kitten “Swapper” 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 thinks he won the war, we changed his name to “Fluffy”. And yes, my niece looks forward to putting pink ribbons on him.
1 For purposes of simplicity, this blog deals with the impact on US Dollar rates.