On October 23, 2020, ISDA published its long-awaited IBOR Fallbacks Supplement to the 2006 ISDA Definitions (the Supplement) and Protocol. The publication is a result of years of consultations with regulators and market participants and seeks to provide a solution for the trillions of dollars of IBOR-referencing derivatives contracts. The Supplement and Protocol provide a standardised and efficient means of transitioning derivatives contracts currently referencing IBORs to risk-free rates. At present, uptake and market acceptance of these changes has been resounding, as over 700 parties have adhered to the Protocol less than four weeks after its launch.
How do the Protocol and Supplement work?
The Supplement and Protocol will become effective on January 25, 2021 (the Protocol Effective Date).
New trades: When it becomes effective, the Supplement amends the 2006 ISDA Definitions by, among others, including fallbacks to the risk free rates in the relevant IBOR definitions. The new fallbacks will apply to all new trades entered into on or after the Protocol Effective Date which reference the 2006 ISDA Definitions.
Legacy trades: The Protocol allows adhering parties to incorporate the amendments introduced by the Supplement into their legacy trades with effect from the Protocol Effective Date. Both parties to a transaction must have adhered to the Protocol for the amended IBOR definitions to apply to their legacy trades. The Protocol permits parties to amend additional agreements (other than ISDA Master Agreements) that reference IBORs such as GMRA and GMSLAs in this way as well. These additional agreements are set out in the Additional Documents Annex to the Protocol.
Parties can adhere to the Protocol via the relevant link on ISDA’s website. Parties have been able to adhere to the Protocol since early-October 2020, and will continue to be able to adhere for the foreseeable future, including after the Protocol Effective Date. Adherence to the Protocol is free until the Protocol Effective Date for ISDA members and non-members, though ISDA Primary Members will be charged a $500 fee. After the Protocol Effective Date, the $500 fee will apply to all.
When will the changes be triggered?
In order for the fallbacks to be triggered, the Supplement and Protocol require one of a number of events to occur. These require a public statement by the administrator of the relevant IBOR (or other entity referred to in the definitions) that (i) that administrator has ceased or will cease to provide the relevant IBOR permanently or indefinitely, or (ii) the relevant IBOR is no longer, or as of a specified future date will no longer be, representative of the underlying market, and that such statement is being made in the knowledge that it would engage contractual triggers. The second leg of these is termed a “pre-cessation trigger”, as it could occur while the relevant IBOR continues to be published.
Upon the occurrence of either of the above referenced events (i.e. those events set out on in (i) and (ii) above), (an “Index Cessation Event”) will be deemed to have occurred, upon which date the spread adjustment applicable to the fallback rate (to which, see below) will be fixed. However, the actual fallback to the risk-free rate will not take place until the Index Cessation Effective Date (the date on which the relevant IBOR actually ceases to be published, or ceases to be considered representative).
What do the risk-free rate fallbacks consist of?
The fallback mechanism will vary depending on the relevant IBOR that the contract is falling back from. With respect to GBP LIBOR, the fallback waterfall can be summarised as follows:
- The Fallback Rate (i.e. the SONIA rate published by Bloomberg).
- SONIA (i.e. the SONIA rate published by the Bank of England), to which the Calculation Agent shall apply the most recently published spread.
- GBP Recommended Rate (i.e. the rate recommended as the replacement for SONIA by SONIA’s administrator, or by a committee designated by the FCA and Bank of England), to which the Calculation Agent shall apply the most recently published spread.
- UK Bank Rate (i.e. the official bank rate published by the Bank of England), to which the Calculation Agent shall apply the most recently published spread.
In respect of USD LIBOR, the fallback waterfall is as follows:
- The Fallback Rate (i.e. the term adjusted SOFR plus the spread, as published by Bloomberg).
- SOFR (i.e. the SOFR rate published by the Federal Reserve Bank of New York), to which the Calculation Agent shall apply the most recently published spread.
- Fed Recommended Rate (i.e. the rate recommended as the replacement for SOFR by the Federal Reserve Board or the Federal Reserve Bank of New York, or by a committee endorsed or convened by the Federal Reserve Board or the Federal Reserve Bank of New York), to which the Calculation Agent shall apply the most recently published spread.
- Overnight Bank Funding Rate (as provided by the Federal Reserve Bank of New York), to which the Calculation Agent shall apply the most recently published spread.
- Short-term interest rate target set by the Federal Open Market Committee and published on the Federal Reserve’s website or, if a single rate is not published, the mid-point of the target range set (again, to which the Calculation Agent shall apply the most recently published spread).
To review the fallbacks for other IBORs (including, among others, CHF LIBOR, JPY LIBOR and EURIBOR), please see the relevant sections of the Supplement.
The “Fallback Rate” for each applicable IBOR shall be the relevant risk-free rate, adjusted by compounding it over the relevant period, plus a “spread adjustment” to compensate for the absence of a credit risk element in risk-free rates (as is inherent in IBORs). Following extensive consultations with market participants, ISDA have based this spread adjustment on the median over a five-year lookback period between the relevant IBOR and risk-free rate. Upon the occurrence of an Index Cessation Event, this spread adjustment will be fixed, and will begin to be published by Bloomberg.
To reflect the inherent difference between IBORs as term rates (whereby the rate for an interest period will be known at the beginning of that period) and risk-free rates as overnight rates (whereby the rate will not be known until the end of the interest period), a two-day lag mechanism is introduced at the end of the interest period. This means that the observation period will end two days before the last day of the accrual period, giving parties crucial time to make the operational arrangements necessary for payments to be made.
Bilateral amendment templates
ISDA recommends adherence to the Protocol as a primary course of fallback implementation for legacy contracts. However, in recognition of the fact that total adherence may not be suitable for all transactions, they have published a number of bilateral templates to allow parties to bilaterally implement the Protocol into their transactions, with scope for bespoke amendments to the Protocol to be made when doing so.
These templates permit the parties to agree, among other things, the inclusion or exclusion of certain specified agreements from the scope of the Protocol. This can be particularly useful for counterparties who have already negotiated their own bespoke fallbacks in certain trades, and do not want the Protocol’s amendments to override them.
A key area in which these bilateral templates can assist parties is when derivatives are used to hedge exposures under cash instruments, such as loans and bonds. In such instances, where a derivative hedges the interest rate exposure of a loan/bond, parties should be wary that adherence to the Protocol could lead to a mismatch between the LIBOR fallbacks in the hedge and the associated loan/bond. As such, market participants may prefer that the fallback language in the hedge mirrors that which is in the associated loan/bond, to minimise basis risk, prevent any slippage and avoid any differences in the pre-cessation triggers. ISDA recognised these points and have developed a bilateral template to allow parties to amend the Protocol such that the hedge fallbacks mirror those in an associated loan/bond.
As the world of LIBOR is being left behind and replaced with risk free rates, market participants should, if they have not done so already, carefully consider their outstanding IBOR exposures and consider whether blanket adherence to the Protocol is appropriate, or whether they should bilaterally amend certain trades (either using ISDA’s bilateral templates, or through active negotiation with their counterparties). Even when parties do choose adhere to the Protocol, ISDA have been keen to communicate that parties should view it as an “airbag” that should only be used if necessary, with active transition continuing to be recommended as the primary course of action.