In a move that coincided with statements by regulators on both sides of the Atlantic that interbank offered rates (each an “IBOR”) will in time be discontinued, on July 12, 2018, the International Swaps and Derivatives Association, Inc. (“ISDA”) published a consultation document (the “Consultation”) requesting market input on two technical issues relating to the transition away from the use of IBORs in the derivatives markets. The first issue relates to the adjustments to the overnight risk-free rates expected to supplant the IBORs (each an “RFR”) that are required to make such overnight RFRs comparable to the relevant IBORs, which are term rates. The second issue relates to the manner in which a spread may be added to the RFRs to account for the counterparty credit risk and liquidity considerations that are reflected in an IBOR but not in an RFR.
The subject matter of the Consultation is mathematically dense. ISDA included with the Consultation two Annexes setting out related mathematical formulae, and the Consultation states ISDA’s intention to conduct webinars, maintain an email address for questions, and publish graphs illustrating the different approaches that the Consultation suggests. For most attorneys, the primary takeaway from the Consultation will likely be not the details of the mathematical approaches that ISDA has suggested but rather the Consultation’s confirmation of ISDA’s overall approach to the phase-out of the IBORs. Specifically, the Consultation states that:
- ISDA intends to amend its 2006 ISDA Definitions, which typically apply to interest rate derivatives, to include fallbacks that would apply upon the permanent discontinuation of certain IBORs. The amended definitions will apply to transactions that incorporate the 2006 ISDA Definitions and are entered into on or after the date on which ISDA publishes the amended definitions.
- The fallbacks contained in the planned amendments to the 2006 ISDA Definitions will not automatically apply to transactions entered into prior to the date on which ISDA publishes the planned amendments. With respect to those transactions, ISDA will publish a protocol (or protocols) by which market participants may agree to incorporate into their legacy transactions with other adherents the fallbacks contained in the planned amendments.
- To provide certainty and avoid disputes, ISDA will select, by means of a request-for-proposal process, an independent third-party vendor to calculate and publish the adjusted RFRs and spread adjustments. ISDA expects to work with the selected vendor to build out the selected approach or approaches (if different approaches are selected for different currencies).
While the Consultation covers only certain IBORs (and does not cover such important benchmarks as USD LIBOR and EURIBOR) the market’s responses to the Consultation will likely help to guide ISDA’s approach to other IBORs as well. The Consultation notes that, given the importance of the IBORs across markets, ISDA believes it appropriate to request input from a wide variety of market participants, including those outside of the derivatives markets.
The levels of the IBORs are generally calculated based on quotations provided by certain major market participants for actual or purported interbank offered loans. Parties submit such quotations for loans of varying lengths (for example, one, three, six, or twelve months). Thus the IBORs reflect a term structure. In addition, because the IBORs represent actual or purported interbank loans, they implicitly reflect counterparty credit risk and liquidity considerations.
The RFRs that regulatory agencies have selected to supersede the IBORs are generally overnight rates and thus do not reflect a term structure. Moreover, they are intended to be riskless, or nearly so, and do not reflect credit risk. However, a great many derivatives are transacted based on term interest rates (in many cases, to hedge other obligations that are also based on term rates), and many parties to bilateral derivatives do, to varying degrees, take credit risk to each other.
With respect to the adjustment of the overnight RFRs to make them comparable to term IBORs, the Consultation suggests the potential use of (i) a spot overnight rate, (ii) a convexity-adjusted overnight rate, (iii) a compounded rate setting in arrears, or (iv) a compounded rate setting in advance.
With respect to the addition of a spread to the RFRs, the Consultation suggests (i) a forward approach, in which the spread adjustment would be calculated based on observed market prices for the forward spread between the relevant IBOR and the adjusted RFR in the relevant tenor at the time when the fallback is triggered; (ii) an historical mean or median approach, in which the spread adjustment would be based on the mean or median spot spread between the IBOR and the adjusted RFR calculated over a static lookback period prior to the triggering of the fallback provisions; or (iii) a spot-spread approach, in which the spread adjustment would be based on the spot spread between the IBOR and the adjusted RFR on the day preceding the triggering of the fallback provisions.
The Consultation requests that responses be submitted online by October 12, 2018.