ISDA publishes consultation on benchmark fallbacks. As part of an initiative to amend its standard derivatives documentation to facilitate the replacement of existing interbank offered rates (IBORs) by risk free rates (RFRs), the International Swaps and Derivatives Association (ISDA) has published a consultation paper on certain adjustments required to such RFRs.

Interbank offered rates (IBORs), such as the London Interbank Offered Rate (LIBOR) and the Euro Interbank Offered Rate (EURIBOR) are average rates at which certain banks could borrow in the interbank market. IBORs typically range in tenors from overnight to 12 months. They include a spread reflecting the credit risk involved in lending money to banks. IBORs play a vital role in financial markets as reference interest rates to huge numbers of derivative contracts, bond, loan and securitisation transactions and deposits. However, there are serious concerns about the reliability and robustness of certain IBORs due to a sharp decline in activity in the interbank funding markets which they are supposed to represent. The main concern about IBORs is that they are anchored in quotes provided by participating panel banks instead of actual transactions. This makes IBORs sensitive to manipulation. To address these concerns, global regulators and public-/private working groups have undertaken significant efforts to identify alternative (nearly) risk free rates (RFRs). The transition from IBORs to the use of these RFRs will be an immensely complicated process which will require huge efforts from both market regulators and participants [1]. To make matters worse, the transition is subject to substantial time pressure. In November 2017, the UK Financial Conduct Authority issued a statement indicating that the panel banks supporting LIBOR are committed to so until 2021. Thereafter, LIBOR may no longer be available. There is even more time pressure with respect to EURIBOR. Currently, EURIBOR's quote-based methodology does not comply with the Benchmark Regulation (BMR) [2]. The BMR provides for a two year transition period that will expire on 1 January 2020. There are concerns that the European Money Markets Institute (EMMI) in its role as the current administrator of EURIBOR will not succeed in transforming EURIBOR in a fully transaction-based methodology. EMMI has already decided that publication of the 2 week, 2 month and 9 month tenors will be discontinued as per 3 December 2018 [3].

One of the initiatives to support the transition from IBORs to RFRs in the derivatives market is the preparation by the International Swaps and Derivatives Association (ISDA) of certain amendments to its standard documentation to implement fallbacks (to selected RFRs) for certain key IBORs. These RFR fallbacks would apply upon the permanent discontinuation of those key IBORs. The amendments will be incorporated by means of a supplement to the 2006 ISDA definitions, which include standard provisions regarding interest rate swaps and other interest rate derivative contracts, including an existing fallback option with respect to an event whereby an applicable IBOR becomes temporarily unavailable. Without the envisaged amendment, the existing fallback option is deemed insufficiently robust in case the applicable IBOR would become permanently unavailable. Following the amendment of the 2006 ISDA definitions, transactions that are subject to those definitions and that are entered into after the date of the amendment, will include a floating rate option that provides for the relevant RFR fallback. 'Legacy' transactions that are entered into prior to the amendment of the 2006 ISDA definitions will be subject to the 2006 ISDA definitions as they were prior to the amendment. ISDA has indicated that they expect to publish a protocol which allows for multilateral amendments pursuant to which the existing floating rate option that applies to the legacy transactions entered into between adhering parties will include the RFR fallback option [4].

As part of the preparation process, ISDA has launched on 13 July 2018 a consultation paper on the approach for addressing certain technical issues associated with adjustments that will apply to the RFRs if the fallbacks are triggered [5]. These adjustments are required because of the differences between the IBORs and the RFRs. The consultation focuses on the following IBORs: GBP LIBOR, CHF LIBOR, JPY LIBOR, TIBOR, Euroyen TIBOR and BBSW. ISDA has announced that it will subsequently publish consultations covering the adjustments required with respect to USD LIBOR, EUR LIBOR and EURIBOR.

What are the differences between the IBORs and the RFRs that require adjustment? The first difference is the fact that RFRs are overnight rates whereas IBORs are term rates published for various tenors. In its consultation paper, ISDA proposes that the fallbacks it intends to introduce will apply an adjustment to the relevant overnight RFR so that it is comparable to the relevant IBOR [6]. The following four adjustment method options are introduced in the consultation paper: (1) the "spot overnight rate" approach, which is based on a RFR that sets on the date that is one or two business days prior to the beginning of the relevant IBOR tenor, (2) the "convexity-adjusted overnight rate" approach, which is similar to the spot overnight rate approach, but attempts to account for the difference between flat overnight interest at the spot overnight rate versus the realised rate of interest that would be delivered by daily compounding of the RFR over the IBOR's term, (3) the "compounded setting in arrears rate" approach, which is based on the relevant RFR observed over the relevant IBOR tenor and compounded daily during that period, and (4) the "compounded setting in advance rate" approach, which is mathematically the same as the compounded setting in arrears rate approach but, while the observation period would be equal in length to the IBOR tenor, it would end immediately prior to the start of the relevant IBOR tenor so that the rate would be available at the beginning of that period. Potential advantages and disadvantages for each of these options are discussed in the consultation paper [7].

Another material difference between IBORs and RFRs that requires adjustment is the fact that overnight RFRs are (nearly) risk-free whereas the relevant IBORs incorporate a bank credit risk premium and a variety of other factors, including liquidity and fluctuations in supply and demand. ISDA recognises that it would be impossible to replicate those factors upon a permanent discontinuation of the relevant IBOR, but in its view a spread adjustment could apply to the relevant adjusted RFR as a rough proxy. The following three methodologies for calculating the spread adjustment are being considered in the consultation paper: (1) the "forward approach", which implies that the spread adjustment would be calculated on observed market prices for the forward spread between the relevant IBOR and the adjusted RFR in the relevant tenor at the time the fallback is triggered, (2) the "historical mean/median approach", which would be based on the mean or median spot spread between the IBOR and the adjusted RFR calculated over a significant, static lookback period prior to the time the fallback is triggered, and (3) the "spot-spread approach", which would be based on the mean or median spot spread between the IBOR and the adjusted RFR calculated over a significant, static lookback period prior to the time the fallback is triggered. Potential advantages and disadvantages of these methodologies are discussed in the consultation paper [8]. Nine combinations of the adjusted RFR and spread adjustment methodologies are identified in the consultation paper. The consultation participants are requested to rank those combinations in terms of preferred approach.

The final part of the consultation paper sets out the process for determining selected approaches for calculating adjusted RFRs and the spread adjustment on the basis of the responses received. The consultation period ends on 12 October 2018. Responses to the consultation can be submitted online at: https://www.isda.org/2018/07/10/interbank-offered-rate-ibor-fallbacks-for-2006-isda-definitions. ISDA has announced that it will host two webinars during the consultation period to introduce the consultation and answer questions, the first to occur during the week of 23 July 2018 and the second to occur during the week of 10 September 2018.

The outcome of the consultation process will have an impact on all interest rate derivative transactions that are subject to the 2006 ISDA definitions and are entered into after the amendment as well as on many legacy transactions.