Adjusted benchmark swap

What Is Adjusted Benchmark Swap?

An Adjusted Benchmark Swap refers to a specific type of interest rate swap where the underlying benchmark rate has been modified by the addition of a spread adjustment. This adjustment is typically applied to financial contracts, particularly financial derivatives like interest rate swaps, to ensure continuity and fair value when a widely used reference rate is replaced by a new one. The concept of an Adjusted Benchmark Swap falls under the broader category of Interest Rate Derivatives and Risk Management, as it primarily serves to manage the transition risk associated with changes in financial benchmarks. The "adjusted" component aims to preserve the economic terms of a contract, preventing unintended value transfer between counterparties.

History and Origin

The concept of an Adjusted Benchmark Swap gained prominence during the global transition away from the London Interbank Offered Rate (LIBOR), a benchmark widely used for decades in financial contracts. LIBOR's eventual discontinuation, driven by concerns over its robustness and susceptibility to manipulation, necessitated the development of alternative reference rates (ARRs) like the Secured Overnight Financing Rate (SOFR) in the U.S.⁷.

Interest rate swaps themselves originated in the early 1980s. One of the earliest documented swaps, a currency swap with elements resembling interest rate swaps, occurred in 1981 between IBM and the World Bank. This transaction allowed both entities to achieve more favorable borrowing costs by exchanging debt obligations denominated in different currencies. After this groundbreaking transaction, the market for swaps grew significantly⁶. The need for Adjusted Benchmark Swaps became critical as financial markets moved away from LIBOR, requiring mechanisms to transition trillions of dollars in existing contracts to new, more robust benchmarks without causing disruption or material value shifts. For instance, the Federal Reserve Board adopted a final rule implementing the Adjustable Interest Rate (LIBOR) Act, identifying SOFR-based benchmark rates as replacements for LIBOR in certain financial contracts after June 30, 2023⁵.

Key Takeaways

• An Adjusted Benchmark Swap modifies a standard interest rate swap by incorporating a spread adjustment to the new reference rate.
• It is crucial for maintaining the economic equivalence of financial contracts when a benchmark rate, such as LIBOR, is discontinued or replaced.
• The adjustment aims to compensate for the inherent differences between the old and new benchmark rates.
• These swaps are a key component of the broader benchmark reform efforts in global financial markets.
• The application of a spread adjustment helps mitigate potential value transfer between counterparties.

Formula and Calculation

The calculation for an Adjusted Benchmark Swap generally involves taking the new benchmark rate and adding or subtracting a predetermined spread adjustment. This adjustment is designed to account for historical differences between the legacy rate (e.g., LIBOR) and the new replacement rate (e.g., SOFR).

For example, in the context of the LIBOR-to-SOFR transition, the International Swaps and Derivatives Association (ISDA) developed fallback language that defines the adjusted SOFR. The formula can be conceptualized as:

$\text{Adjusted Benchmark Rate} = \text{Replacement Benchmark Rate} + \text{Spread Adjustment}$

Where:

• Adjusted Benchmark Rate: The rate used for calculating the floating rate leg of the swap.
• Replacement Benchmark Rate: The new, robust reference rate (e.g., SOFR, Term SOFR).
• Spread Adjustment: A specific value, often calculated as the historical median difference between the original benchmark and the new replacement rate over a defined period. For instance, ISDA's 2020 Fallbacks Protocol suggests a spread adjustment calculated via historical median differences between LIBOR and SOFR over five years⁴.

This formula ensures that the new rate, once adjusted, closely approximates the economics of the original contract.

Interpreting the Adjusted Benchmark Swap

Interpreting an Adjusted Benchmark Swap centers on understanding how the inclusion of the spread adjustment impacts the financial obligations of the counterparties involved. The primary goal of the adjustment is to minimize any unintended value transfer that would otherwise occur due to the inherent differences between the old and new benchmark rate. For instance, SOFR, being a secured overnight rate, typically trades lower than LIBOR, which included a credit component. Without an adjustment, a transition from LIBOR to unadjusted SOFR would benefit the payer of the floating rate and disadvantage the receiver.

Therefore, when evaluating an Adjusted Benchmark Swap, participants analyze the chosen replacement benchmark rate and the method used to determine the spread adjustment. The accuracy and fairness of this adjustment are crucial. A well-designed Adjusted Benchmark Swap aims to maintain the original economic intent of the contract, allowing parties to continue managing their exposure to interest rate fluctuations effectively without being materially impacted by the benchmark transition itself.

Hypothetical Example

Consider two companies, Company A and Company B, that entered into an interest rate swap years ago. Company A pays a fixed rate of 3.00% on a $100 million notional principal, and Company B pays a floating rate based on LIBOR. With LIBOR's discontinuation, their swap needs to transition to SOFR.

Assume the following:

• Original floating rate: 3-month USD LIBOR
• New replacement rate: 3-month Term SOFR
• ISDA-mandated historical spread adjustment for 3-month USD LIBOR to 3-month Term SOFR: 0.26161% (or 26.161 basis points).

Under the terms of their Adjusted Benchmark Swap:

1. Determine the Adjusted Benchmark Rate: If the 3-month Term SOFR for a given period is 4.50%, the Adjusted Benchmark Rate would be:

   • Adjusted Benchmark Rate = Term SOFR + Spread Adjustment
   • Adjusted Benchmark Rate = 4.50% + 0.26161% = 4.76161%

2. Calculate Company B's Payment: Company B, the floating-rate payer, would pay interest based on this Adjusted Benchmark Rate.

   • Company B's floating payment = Notional Principal × (Adjusted Benchmark Rate / number of periods per year)
   • Company B's floating payment = $100,000,000 × (0.0476161 / 4) = $1,190,402.50 (for a quarterly payment)

3. Company A's Payment Remains Fixed: Company A continues to pay its fixed rate of 3.00% on the $100 million notional.

   • Company A's fixed payment = $100,000,000 × (0.03 / 4) = $750,000 (for a quarterly payment)

In this Adjusted Benchmark Swap, the spread adjustment ensures that Company B's floating payment reflects an amount closer to what it would have been under LIBOR, thus maintaining the financial balance of the original agreement.

Practical Applications

Adjusted Benchmark Swaps are primarily applied in contexts where financial contracts linked to legacy benchmark rates need to transition to new, more robust alternatives. Their practical applications span several areas:

• Legacy Contract Transition: The most significant application is in the smooth transition of "tough legacy" financial instruments, such as bonds, loans, and particularly interest rate swaps, from discontinued rates like LIBOR to new risk-free rates (RFRs) like SOFR. The adjustment ensures that the change in the underlying benchmark does not lead to an unintended transfer of value between the parties.
• Risk Management: For financial institutions and corporations, Adjusted Benchmark Swaps are vital tools for risk management. They allow entities to continue hedging interest rate exposure without facing significant basis risk or market disruption caused by the benchmark transition. They help maintain the efficacy of existing hedge relationships.
• Derivatives Market Continuity: These swaps underpin the continuity of the vast global financial derivatives market. By providing a standardized mechanism for adjusting rates, they prevent widespread re-negotiation or termination of contracts, which would otherwise be costly and disruptive. The U.S. Commodity Futures Trading Commission (CFTC) provides data and analysis on the significant role of interest rate swaps in risk transfer within financial markets, highlighting the importance of clear benchmarks and adjustment mechanisms for market stability.
  *³ Pricing and Valuation: They provide a framework for the consistent pricing and valuation of financial instruments during periods of benchmark reform. The spread adjustment becomes a critical input in pricing models for new and existing derivatives.

Limitations and Criticisms

Despite their critical role in ensuring continuity during benchmark transitions, Adjusted Benchmark Swaps are not without limitations or criticisms.

One primary concern relates to the methodology and transparency of the spread adjustment. While industry bodies like ISDA have provided standardized approaches, calculating a "fair" adjustment that perfectly reflects the economic differences between a legacy rate (like LIBOR, which included a credit risk component) and a new, nearly risk-free rate (like SOFR) can be complex. Critics may argue that any historical lookback period used for calculation might not perfectly capture future market dynamics or the specific credit profile embedded in the original transaction.

Another limitation arises from the potential for basis risk, even with adjustments. While the spread adjustment aims to bridge the gap between benchmarks, it cannot fully eliminate all differences, particularly those related to the underlying market dynamics or the tenor structures. For example, a floating rate based on an overnight rate compounded in arrears (like SOFR) behaves differently than a forward-looking term rate (like former LIBOR), potentially creating residual basis risk that needs to be managed. Research published by the Federal Reserve Bank of New York has examined how trading risk can affect the volatility of interest rate swap spreads, noting that speculative trading activity can sometimes cause divergence from long-run levels. T²his highlights the inherent complexities and potential for unexpected movements even in a well-established swap market.

Furthermore, the legal and operational complexities of transitioning millions of existing "tough legacy" contracts to Adjusted Benchmark Swaps posed significant challenges. While legislative solutions, such as the LIBOR Act in the U.S., were enacted to provide a uniform replacement process, some contracts may still face ambiguities, leading to potential disputes or operational hurdles in cash flow calculations.

Adjusted Benchmark Swap vs. Benchmark Replacement Conforming Changes

While closely related, "Adjusted Benchmark Swap" and "Benchmark Replacement Conforming Changes" refer to different aspects of the same underlying financial market evolution.

An Adjusted Benchmark Swap specifically describes an interest rate swap where the floating leg's underlying benchmark rate has been explicitly adjusted—typically by adding a spread adjustment—to account for the transition from a prior, now-discontinued, reference rate. It describes the state or characteristic of the swap itself after such a modification.

Benchmark Replacement Conforming Changes, on the other hand, refers to the broader set of modifications, amendments, or adjustments made to the terms of a financial contract (which could include a swap, but also loans, bonds, etc.) that are necessary to facilitate the replacement of an original benchmark rate with a new one. These changes encompass not only the application of a spread adjustment but also any other consequential alterations to payment schedules, interest rate calculations, or operational procedures needed to ensure the contract remains valid and consistent under the new reference rate. In es¹sence, an Adjusted Benchmark Swap is a result of applying Benchmark Replacement Conforming Changes to an existing swap contract.

FAQs

What prompted the creation of Adjusted Benchmark Swaps?

Adjusted Benchmark Swaps emerged primarily due to the discontinuation of widely used benchmark rates, most notably LIBOR. The need arose to transition existing contracts that referenced these rates to new, more robust alternatives (like SOFR) while minimizing value transfer and disruption.

Is an Adjusted Benchmark Swap a new type of derivative?

No, an Adjusted Benchmark Swap is not a fundamentally new type of financial derivatives instrument. It is an existing interest rate swap that has been modified or amended to incorporate a new benchmark rate plus a spread adjustment, ensuring continuity from a legacy benchmark.

How is the spread adjustment determined for an Adjusted Benchmark Swap?

The spread adjustment is typically determined through standardized methodologies established by industry bodies like ISDA. For the LIBOR transition, this often involved calculating the historical median difference between the original LIBOR rate and the new replacement rate (e.g., SOFR) over a specific lookback period. This aims to ensure the continuity of cash flow expectations.

Who uses Adjusted Benchmark Swaps?

Financial institutions, corporations, and other market participants holding or entering into over-the-counter (OTC) interest rate swaps that are transitioning from a legacy benchmark rate to a new one utilize Adjusted Benchmark Swaps. They are crucial for managing existing interest rate exposures and ensuring the continued effectiveness of hedging strategies.