A closer look at ISDA's new 2020 IBOR Fallbacks Protocol and amendments to 2006 definitions
Would Provide Parties with Uniform Way to Address Existing and New Derivatives Contracts After Discontinuation of Libor
- The International Swaps and Derivatives Association Inc. (ISDA) has published its 2020 IBOR Fallbacks Protocol and related Amendments to the 2006 ISDA Definitions to address discontinuation of the U.S. dollar (USD) Libor and other interbank offered rates (IBORs) in the global derivatives market. USD Libor is anticipated to be discontinued at the end of 2021.
- Existing derivatives transactions will require a bilateral amendment to adequately address USD Libor discontinuation. The Protocol provides a uniform, market-wide mechanism for parties to voluntarily amend existing derivatives contracts to address USD Libor discontinuation.
- Amendments to the 2006 Definitions will provide a similar USD Libor fallback mechanism for new derivatives transactions that incorporate the 2006 Definitions.
The International Swaps and Derivatives Association Inc. (ISDA) has published its long-awaited 2020 IBOR Fallbacks Protocol (the Protocol) and related Amendments to the 2006 ISDA Definitions (the Amendments). These documents, together, represent a significant step toward the bilateral modification of global derivatives documentation to address the anticipated discontinuation of Libor (the London Interbank Offered Rate), including the U.S. dollar (USD) Libor, at the end of 2021. It is anticipated that the widespread, voluntary adoption by the market of these standardized terms for the fallback from Libor will impact derivatives transactions with trillions of dollars in notional amount. ISDA has also published a set of Frequently Asked Questions relating to the Protocol.
What Is Libor and Why Is It Going Away?
Libor, one of the most widely used interest rate benchmarks in the world, underlies an estimated $350 trillion of outstanding contracts in maturities ranging from overnight to more than 30 years, according to its administrator, the Intercontinental Exchange (ICE) Benchmark Administration. Each London business day, Libor is produced for five currencies with seven maturities, based on an average of rates provided by a panel of participating banks, with each bank indicating the rate at which it could obtain unsecured funding for a given period in a given currency.
In 2013, against a backdrop of scandals regarding the manipulation of Libor and decreased liquidity in interbank lending, the Financial Stability Board (FSB), a global body that monitors the world's financial systems, established the Official Sector Steering Group (OSSG), consisting of senior officials from central banks and regulatory authorities, to coordinate the review and reform of global interest rate benchmarks. In 2016, the OSSG launched a new initiative, focusing on the improvement of contract robustness to address concerns regarding the discontinuation of certain key interest rate benchmarks. The OSSG invited ISDA to lead the initiative with respect to discontinuation and fallbacks in the derivatives market.
Efforts regarding discontinuation of key benchmarks took on an increased urgency in 2017, as the United Kingdom's Financial Conduct Authority (FCA), the regulator of Libor, announced that it would no longer compel participating banks to provide submissions beyond 2021, giving the global financial system only a few years to prepare for the possible end of Libor.
In light of the COVID-19 pandemic, regulators and other officials have confirmed that they do not anticipate any change in the timing of the discontinuation of Libor and that market participants should proceed on that basis. In fact, some regulators have indicated that, as a result of market activity, certain Libor currencies and tenors could cease to be representative of the underlying market prior to the end of 2021, which could potentially trigger a fallback with respect to those Libor rates ahead of actual discontinuation.
What Benchmark Will Replace USD Libor?
In 2014, in response to recommendations of the FSB, the Federal Reserve System and the Federal Reserve Bank of New York jointly created the Alternative Reference Rates Committee (ARRC), consisting of a wide variety of market participants, trade organizations and ex officio regulators. In 2017, the ARRC identified the Secured Overnight Financing Rate (SOFR) as the replacement for USD Libor. SOFR, published daily and administered by the Federal Reserve Bank of New York, is based on more than $700 billion in overnight repurchase transactions secured by U.S. Treasury securities. It is described by the Federal Reserve Bank of New York as a "broad measure of the cost of borrowing cash overnight collateralized by Treasury securities." ISDA subsequently agreed that SOFR would be the "risk-free" alternative to USD Libor for derivatives purposes as well. It should be noted that, although the ARRC and ISDA have identified SOFR as the recommended alternative to USD Libor, the adoption of SOFR as a fallback to USD Libor is purely voluntary. Other alternative fallback rates exist and may be agreed upon under certain circumstances.
How Would Discontinuation of USD Libor Impact Existing Derivatives?
The vast majority of the world's derivatives transactions are documented under standardized master agreements and definitions published by ISDA, including the 2006 Definitions. The existing ISDA definitions for USD Libor (identified in the 2006 Definitions as USD-LIBOR-BBA and USD-LIBOR-BBA-Bloomberg) did not anticipate the permanent discontinuation of the rate. Although the 2006 Definitions include certain fallback provisions, they were intended primarily to address short-term disruptions in the publication of USD Libor. In the first instance, if USD Libor is not published, the 2006 Definitions call for the calculation agent (usually one of the parties to the transaction) to determine the fallback rate by polling banks in the London market and then, failing that, polling banks in the New York market, for interbank lending rates. In addition to the risk that banks simply refuse to provide requested rates, the sheer volume and scope of transactions referencing USD Libor would make this approach impractical at best, inconsistent from transaction to transaction and potentially impossible to carry out, leaving trillions of dollars of derivative transactions with no methodology to calculate the floating rate or to determine the market value. As bilateral contracts, any alternate methodology for replacement of the USD Libor floating rate would have to be agreed upon by both parties.
How Does the Protocol Address Discontinuation of USD Libor?
The Protocol provides a mechanism for parties to bilaterally amend their existing derivatives transactions to incorporate ISDA's fallback terms, providing for a clear transition from USD Libor to SOFR upon the occurrence of certain objective, easily observable events, avoiding the existing, inadequate fallback mechanics. The Protocol's fallback terms are intended to match the fallback terms that are incorporated into the Amendments to the 2006 Definitions, creating a uniform fallback, synchronized in both timing and rate, across existing transactions and new transactions. The actual replacement mechanics are described in more detail below.
How Does a Party Use the Protocol?
A party's agreement to use the Protocol is referred to as "adherence." The process of adherence can be done directly through ISDA's website and requires a party to execute a short form of Adherence Letter and upload a PDF to ISDA's portal. Names of adhering parties will be published on ISDA's website. For parties that are "ISDA Primary Members," the cost will be $500. For all other parties, adherence will be free if done prior to Jan. 25, 2021 (the Protocol Effective Date). The Protocol is open to all market participants, regardless of domicile, and parties do not need to be ISDA members to adhere. There is currently no cutoff date, so parties may adhere at any time. ISDA has also provided a method for parties to revoke their adherence, subject to certain conditions.
What Happens After a Party Adheres to the Protocol?
After a party has adhered, the Protocol will, subject to the timing described below, amend "Protocol Covered Documents" entered into between that party and all other adhering parties to incorporate the USD Libor fallback provisions. By default, Protocol Covered Documents include a) Protocol Covered Master Agreements (including ISDA Master Agreements that incorporate the 2006 Definitions or other covered ISDA Definitions, or otherwise reference a covered IBOR, including USD Libor), b) Protocol Covered Credit Support Documents (including any ISDA Credit Support Document that incorporates the 2006 Definitions or other covered ISDA Definitions, or otherwise references a covered IBOR, including USD Libor), and c) Protocol Covered Confirmations (including Confirmations that incorporate the 2006 Definitions or other covered ISDA Definitions, or otherwise reference a covered IBOR, including USD Libor). Parties may also elect to include certain non-ISDA documents as Protocol Covered Documents. The agreement between two adhering parties to incorporate the Protocol amendments will be deemed effective on the date of adherence by the latter of the two parties (the Implementation Date), unless one or both parties have adhered through an agent, which is subject to other terms. The actual amendments to any two parties' Protocol Covered Documents will not become effective until the later of the Implementation Date and the Protocol Effective Date. As a result, ISDA is providing the market with a forward period, during which it is anticipated that many market participants will adhere, but during which the underlying amendments will not be effective. The Protocol amendments will become effective on Jan. 25, 2021. for all market participants who have adhered during that period.
Which ISDA Definitions Are Covered by the Protocol?
The Protocol will cover transactions that are governed by a Master Agreement and incorporate the 2006 ISDA Definitions, the 2000 ISDA Definitions, the 1998 ISDA Euro Definitions, the 1998 Supplement to the 1991 ISDA Definitions and the 1991 ISDA Definitions (each a Covered ISDA Definitions Booklet). In addition, the Protocol will cover any transaction that is governed by an ISDA Master Agreement and that references one of the USD Libor rates either "as defined" in one of the Covered ISDA Definitions Booklets or otherwise.
Can Parties Use the ISDA Amendment Fallbacks Without Adhering to the Protocol?
Yes, ISDA has provided various forms of bilateral agreements for parties to use. These forms allow two counterparties to agree to incorporate the terms of the Protocol, either verbatim or subject to modifications agreed to between the parties. These bilateral agreements will only impact the transactions between the two parties – they will not impact any agreements or transactions with third parties.
When Will the Floating Rate Convert from USD Libor to SOFR?
The Protocol and Amendments provide that the floating rate will fall back from USD Libor to SOFR upon the occurrence of an Index Cessation Effective Date. For USD Libor, an Index Cessation Effective Date will occur, following an Index Cessation Event, on the first date on which 1) the relevant USD Libor rate is non-representative (pursuant to clause 3 of the Index Cessation Events listed below) or 2) the relevant USD Libor rate is no longer provided.
Index Cessation Events are intended to be objective triggers based on easily observable events. For purposes of USD Libor, Index Cessation Events consist of the following:
- a public statement or publication of information by or on behalf of the administrator of USD Libor announcing that it has ceased or will cease to provide USD Libor permanently or indefinitely, provided that, at the time of the statement or publication, there is no successor administrator that will continue to provide USD Libor
- a public statement or publication of information by the regulatory supervisor for the administrator of USD Libor, the central bank for the currency of USD Libor, an insolvency official with jurisdiction over the administrator for USD Libor, a resolution authority with jurisdiction over the administrator for USD Libor, or a court or an entity with similar insolvency or resolution authority over the administrator for USD Libor, which states that the administrator of USD Libor has ceased or will cease to provide USD Libor permanently or indefinitely, provided that, at the time of the statement or publication, there is no successor administrator that will continue to provide USD Libor, or
- a public statement or publication of information by the regulatory supervisor for the administrator of USD Libor announcing a) that USD Libor is no longer, or as of a specified future date will no longer be, capable of being representative, or is non-representative, of the underlying market and economic reality that USD Libor is intended to measure as contemplated by applicable law or regulation and as determined by the regulatory supervisor as contemplated by applicable law or regulation and b) that the intention of that statement or publication is to engage contractual triggers for fallbacks activated by pre-cessation announcements by such supervisor (howsoever described) in contracts
With respect to clause 3 above, it should be noted that ISDA has published standard forms of bilateral amendments that may be used by parties wishing to disapply the pre-cessation trigger described in that clause 3.
It is anticipated that the relevant regulatory and administrative bodies will, when appropriate, unambiguously make the required statements. As a result, all transactions that are subject to the Protocol or the 2006 Definitions (as amended) will fall back from USD Libor to SOFR at the same time, avoiding any issues relating to timing of fallbacks in the market. This consistent approach is intended to provide a level of certainty to market participants that would otherwise be absent with respect to transactions relying on the current definitional terms.
How Will the SOFR Fallback Rate Be Determined?
The SOFR fallback rate for each tenor of USD Libor, determined for each calculation period, will be calculated as the sum of 1) the Adjusted SOFR Rate plus 2) the Spread Adjustment. This fallback rate is referred to in the Amendments as Fallback Rate (SOFR).
For each calculation period, the "Adjusted SOFR Rate" will be calculated on a compounded basis in arrears, meaning that it will be determined, near the end of each calculation period, based on the average of the overnight SOFR rates observed during that calculation period and compounded daily. For example, for a transaction based on 1-month Libor, the Adjusted SOFR Rate for a calculation period would be based on the overnight SOFR rates for a period of 30 days.
The "Spread Adjustment" will be fixed upon the occurrence of an Index Cessation Event and will be calculated, for each tenor of USD Libor, as the median of the historical difference between such tenor of USD Libor and the compounded overnight SOFR rate for that tenor, observed over the prior five-year period. This adjustment is intended to account for the differences between USD Libor and SOFR, including the fact that USD Libor is an unsecured rate while SOFR is a secured rate. The Spread Adjustment is separate from, and not in lieu of, any spread to USD Libor previously negotiated between the parties. Any such negotiated spread will still be added to the "all-in" SOFR fallback rate to determine the floating rate on any such transactions.
Since the SOFR fallback rate is to be calculated in arrears based on overnight observations during each calculation period, it would not be possible to determine the rate in advance, at the beginning of each calculation period. As a result, the SOFR fallback rate for each calculation period will be determined near the end of the calculation period, two business days prior to the related payment date. This is a significant departure from USD Libor, which, as a forward-looking term rate, is available and known at the beginning of each calculation period, allowing for more precise cash flow and other operational planning.
Will the SOFR Fallback Rates Be Publicly Available?
Yes, ISDA has engaged Bloomberg Index Services Limited (BISL) to calculate and publish the fallback rates. BISL will publish, on a daily basis, the Adjusted SOFR Rate, the Spread Adjustment and the "all-in" fallback rate for each tenor of USD Libor. The information will be publicly available for free on a delayed basis on BISL's website. BISL has already begun publishing indicative data, reflecting what the fallback rates for each tenor of USD Libor would be if an Index Cessation Event had occurred. Under the Protocol and Amendments, BISL's published "all-in" SOFR fallback rates will be the official designated source for the replacement rate for each tenor of USD Libor following the occurrence of an Index Cessation Event.
Will the SOFR Fallback Rate Be the Same as the USD Libor Rate That It Replaces?
Not necessarily. The SOFR fallback rate is not intended to identically match the USD Libor rate that it replaces – the two rates will be calculated based on different data and different methodologies. It is possible that differences between the USD Libor rates and the replacement SOFR rates may result in changes to the mark-to-market value of each affected transaction and could potentially impact related collateral requirements.
Will the Swap Fallback Rates Under the Protocol and Amendments Be the Same as the Fallbacks for Hedged Debt?
Not necessarily. Existing loan documents, especially those that are more than a year old, are likely to have very different fallback provisions from those contained in the Protocol and Amendments. Those loan documents may allow the lender to determine a fallback rate at its discretion or may automatically fall back to an unfavorable rate, such as the prime rate plus a spread or a reversion to the last published USD Libor rate, which could result in a mismatch between the fallback rates under those loans and the fallback rates under any related swaps. Market participants may wish to review their existing loan portfolios and consider the impact of any fallback provisions in the related documents relative to their corresponding hedges.
With respect to new loans, the ARRC has independently developed and published its own series of recommended fallback methodologies for the cash markets, including loans. Although the ARRC has endorsed SOFR as a fallback generally, the implementation of the fallback and calculation of the fallback rates varies among product types. There is no market-wide, uniform solution in the cash markets, which means that different banks may adopt different approaches, with some banks using the ARRC recommendations or some variation thereof and other banks using their own formulations. Differences between these methodologies could result in a mismatch between the fallback rates under those loans and the fallback rates under any related swaps. It is noted that the ARRC has recommended a form of "hedged loan" approach, to be implemented in certain loans that are intended to be hedged, which would reduce the likelihood of basis risk between the loan and hedge fallbacks, but adoption of this approach has not been uniform in the market. Market participants may wish to consider these factors when contemplating new loans that may be hedged with swaps or other derivatives.
What Happens if Fallback Rate (SOFR) Is Unavailable or Discontinued?
The Amendments, which are incorporated by the Protocol, are intended to be much more future-proof than the existing 2006 Definitions. For USD Libor, the first fallback is the Fallback Rate (SOFR), as discussed above. After that, there is a series of replacement rates to be used in the event that any prior fallback rate has become unavailable. If Fallback Rate (SOFR) is temporarily unavailable, the rate for any reset date would be the Fallback Rate (SOFR) as most recently provided or published at that time. If Fallback Rate (SOFR) has been discontinued, the first fallback would be calculated based on published overnight SOFR rates for the relevant calculation period. The Amendments then specify a waterfall of fallback rates to be used, in the following order:
- the Fed Recommended Rate, which is "the rate (inclusive of any spreads or adjustments) recommended as the replacement for SOFR by the Federal Reserve Board or the Federal Reserve Bank of New York, or by a committee officially endorsed or convened by the Federal Reserve Board or the Federal Reserve Bank of New York for the purpose of recommending a replacement rate for SOFR (which may be produced by the Federal Reserve Bank of New York or another administrator) and as provided by the administrator of that rate or, if that rate is not provided by the administrator thereof (or a successor administrator), published by an authorized distributor
- the Overnight Bank Funding Rate, as provided by the Federal Reserve Bank of New York (or a successor administrator) on the New York Fed's website
- the short-term interest rate target set by the Federal Open Market Committee and published on the Federal Reserve's website or, if the Federal Open Market Committee does not target a single rate, the mid-point of the short-term interest rate target range set by the Federal Open Market Committee and published on the Federal Reserve's website
Does the Protocol Address the Discontinuation of Other Benchmarks?
Yes. In addition to fallbacks for USD Libor, the Protocol provides fallbacks for sterling Libor, Swiss franc Libor, euro Libor, the euro interbank offered rate, the Japanese yen Libor, the Japanese yen Tokyo interbank offered rate, the euroyen Tokyo interbank offered rate, the Australian bank bill swap rate, the Canadian dollar offered rate, the Hong Kong interbank offered rate, the Singapore dollar swap offer rate and the Thai baht interest rate fixing. The Protocol also addresses references to Libor generally, where no reference is made to any specific currency. All of these covered benchmarks are referred to in the Protocol as "Relevant IBORs."
What Will Happen with New Transactions?
Transactions entered into on or after Jan. 25, 2021, that incorporate the 2006 ISDA Definitions will automatically incorporate the Amendments, including the relevant fallback provisions.
It is widely agreed that existing swaps, as well as other derivatives referencing USD Libor, will have to be bilaterally modified, preferably in advance, to address the discontinuation of USD Libor. The Protocol provides a uniform, market-wide approach to the fallback, intended to ease the transition for market participants, creating certainty as to the timing of trigger events and calculation of fallbacks across the full spectrum of derivative products. Adherence to the Protocol is, of course, purely voluntary. Market participants should closely review the fallback methodologies and timing issues, and consider the potential impact that adherence might have on their swap and loan portfolios. Similarly, consideration should be given to any new derivative transactions and related loans entered into prior to discontinuation.
Market participants may wish to consult with their legal, tax, financial and accounting advisors with respect to adherence to the Protocol as well as the broader impact of the conversion from USD Libor to SOFR.