LIBOR is dead; long live the RFR: new ISDA fallbacks to address LIBOR
On 23 October, the International Swaps and Derivatives Association, Inc. (ISDA) released the ISDA 2020 IBOR Fallbacks Supplement to the 2006 ISDA Definitions (Supplement) and the IBOR Fallbacks Protocol (Protocol). The Supplement will incorporate amendments to the 2006 ISDA Definitions (Supplement Amendments) to assist derivatives markets participants to adopt overnight risk-free rates (RFRs) as alternative interest rate benchmarks to key interbank offered rates (IBORs), including the London Inter Bank Offered Rate (LIBOR), which is expected to cease after 2021. The Supplement Amendments will improve the robustness of all derivatives contracts which incorporate the 2006 ISDA Definitions by addressing the risk of discontinuation of widely-used IBORs.
Transactions which incorporate the 2006 ISDA Definitions that are entered into on or after 25 January 2021 will automatically include the Supplement Amendments. However, transactions entered into prior to 25 January 2021 (so called ‘legacy derivative contracts’) will continue to be based on the earlier version of the 2006 ISDA Definitions, unless parties contractually agree to incorporate the Supplement Amendments. ISDA has published the Protocol to facilitate contractual agreement between parties who wish to incorporate the Supplement Amendments into legacy derivative contracts between them. Cleared transactions are not covered by the Protocol.
The publication of the Supplement and the Protocol is a welcome development, not only for the derivatives markets, but also for the bond and loan markets. Given the inter-connectivity between these markets, the fallbacks published in the Supplement will provide more certainty for market participants seeking to co-ordinate a seamless LIBOR transition for their exposures across bond, loan and derivatives markets.
- ISDA has published a new Supplement that will replace the fallbacks to key IBOR benchmarks in the 2006 ISDA Definitions with new fallbacks that will come into effect on a temporary or permanent discontinuation of the relevant IBOR benchmark.
- Transactions which incorporate the 2006 ISDA Definitions that are entered into on or after 25 January 2021 will automatically include the Supplement Amendments. However, legacy derivative contracts (those entered into prior to 25 January 2021) will not incorporate the Supplement Amendments, unless parties contractually agree to do so.
- ISDA has published a Protocol to facilitate parties who adhere to the Protocol (Adhering Parties) to incorporate the Supplement Amendments into legacy derivative contracts between them.
- The Protocol will automatically extend to certain non-ISDA documents unless such contracts are bilaterally excluded by the parties. ISDA has published standard form agreements that can be used to amend the scope or effect of the Protocol. These are intended to be used between Adhering Parties or by parties who have not adhered to the Protocol (“Non-adhering Parties”) but have bilaterally adopted the Protocol.
- The fallbacks rates that will replace the IBORs are based on adjusted overnight RFRs. Their use has been endorsed by key regulatory bodies and industry working groups both in Australia and globally (including the Financial Stability Board (FSB), the Bank of England, the US Federal Reserve and the European Union), notwithstanding a number of structural differences between RFRs and IBORs.
- Industry groups are working in parallel to develop possible forward-looking term rates as closer proxies to LIBOR term rates, but in the meantime the market is being encouraged to adopt overnight rates with appropriate adjustments.
- The Supplement Amendments reflect the differing IBOR transition strategies that countries are pursuing. Some countries plan to discontinue their current IBOR and transition completely to an RFR, while others (like Australia) will apply a ‘multiple rate’ approach. Consistent with Australia’s selection of the RBA’s Interbank Overnight Cash Rate (known as ‘AONIA’) as its alternative RFR, the Supplement amendments incorporate new AONIA rate fallbacks into key AUD floating rate options that reference BBSW.
- The Reserve Bank of Australia (RBA), the Australian Prudential Regulation Authority (APRA), and the Australian Securities and Investments Commission (ASIC) will expect all users of BBSW to adopt the BBSW fallbacks published in the Supplement where possible. Consistent with this, the RBA has announced that it will require all floating rate notes that reference BBSW to include the relevant ISDA fallback provisions in order to be to be eligible for the RBA's open market operations.
- To assist market participants to mitigate conduct risk over the LIBOR transition period, ASIC has provided guidance on steps that can be taken by market participants to ensure their clients are fully informed and fairly treated during this period.
- Financial service providers who intend to adhere to the Protocol or incorporate the Supplement Amendments from 25 January 2021 should take note of the above guidance when formulating their internal protocols for managing conduct risk or developing client communications strategies in relation to the Supplement Amendments or their Protocol adherence.
- Following the release of the Supplement and the Protocol, market participants will have more certainty in relation to how derivatives fallbacks will operate and the way forward for new transactions and transitioning legacy transactions. At the same time, any risks inherent in the use of these fallbacks will need to be identified and appropriately managed.
- Market participants will also need to consider whether any amendments should be made to the new fallbacks as they apply to specific derivatives products.
Why are the changes necessary?
The transition from IBORs has been on the global agenda since 2014, when the Financial Stability Board (FSB) released its initial report on reforming major interest rate benchmarks. The report was released amidst the background of attempted market manipulation of IBORs and false reporting of global reference rates. These developments, together with a post-crisis decline in liquidity in interbank unsecured funding markets, had undermined market confidence in the reliability and robustness of IBORs as benchmark reference rates. Because IBORs are used widely as benchmarks for a large volume and broad range of financial products and contracts, including derivatives, bonds and loans, this uncertainty created the potential for serious systemic vulnerability and risk. As such, the FSB’s report recommended a transition away from using IBORs as reference rates to appropriate RFRs.
Significant work has since been undertaken around the globe by a series of working groups to identify the most suitable alternatives to IBORs, based on transactions in interbank unsecured lending markets or repo markets. Although IBORs are generally forward-looking term rates, overnight backward looking RFRs have been endorsed in all the key jurisdictions as suitable alternatives given they are based on actual executed transactions. A number of working groups are working in parallel to develop possible forward-looking term rates as closer proxies to LIBOR term rates, but in the meantime the market is being encouraged to adopt overnight rates, with appropriate adjustments.
Current status of the IBOR transition (Australia in focus)
Following the FSB’s 2014 report, regulators have stepped up their calls to market participants to transition away from IBOR benchmarks and promoted the development and adoption of alternative RFRs, where appropriate. In line with this approach, the UK Financial Conduct Authority (FCA) in July 2017 announced that it would no longer seek to compel or persuade banks on the LIBOR panel to submit quotes for LIBOR by the end of 2021. As a result, there is now widespread recognition that LIBOR is likely to come to an end at this time.
The IBOR transition efforts in Australia have been led by the RBA, the Australian Financial Markets Association (AFMA), ASIC, APRA and the Australian Stock Exchange (ASX).
The focus for the Australian market has been assessing whether there is a case for transitioning the AUD market away from the Bank Bill Swap Rate (BBSW) and encouraging the market to adopt in its place, AONIA. AONIA is calculated and published by the RBA each day and represents a risk free, or close to risk free, weighted average interest rate at which banks are willing to borrow and lend unsecured cash on an overnight basis. In contrast, BBSW is a credit-based interest rate benchmark which represents the midpoint rate for various prime bank eligible securities for tenors between one and six months, and is the rate that banks lend to each other in Australia. The methodology for calculating BBSW was strengthened in 2018.
The Australian regulators have determined that the interbank market supporting BBSW is sufficiently robust for Australia to take a multiple rate approach under which BBSW will co-exist with AONIA. This will allow users of Australian dollar benchmarks to choose the benchmark that is most appropriate for their circumstances. For example, the use of a credit-based benchmark such as BBSW in funding instruments may make more sense for bank issuers. However, a risk-free rate may be more appropriate for government issuers, such as when the South Australian Government Financing Authority issued the first floating rate note referencing AONIA in July 2019.
There is potential for the market to naturally migrate towards AONIA, as other jurisdictions complete their transition from IBOR benchmarks. The inevitability of this will depend in part on how international markets for products such as cross-currency basis swaps transition from LIBOR. In this regard, good progress is being made on developing new market conventions for trading cross-currency basis swaps, referencing RFRs or combinations of RFRs and IBORs. In January 2020, the Alternative Reference Rates Committee (ARRC), a US based group of private market participants, released a final report outlining potential conventions for the use of RFRs in both RFR-RFR and RFR-IBOR cross-currency swaps, leaving it open for Australian dollar cross currency swaps to continue to reference BBSW.
The continuation of BBSW has also received a nod of approval from European regulators following their equivalence recognition of Australia’s regulatory regime for benchmarks in July 2019. This recognition means that BBSW can continue to be used by European Union (EU) supervised entities. Under Europe’s benchmarks regulation (BMR), supervised entities, including banks and central counterparties, can only use benchmarks that are registered in the EU. To achieve this status, benchmarks administered outside the EU (such as BBSW) will need to be administered in a jurisdiction with a legal framework judged by the EU to be ‘equivalent’ to, or substantially comply with, the BMR.
How are other jurisdictions responding to the transition from IBORs?
Countries are taking different approaches to their transition from IBORs. Some countries plan to discontinue their current IBOR and transition completely to an RFR, while others will apply a ‘multiple rate approach’. This requires a country to adopt an existing (or develop a new) RFR, which co-exists alongside an IBOR (which may have been strengthened but remains representative of the underlying market). Examples include Australia, Canada, the EU with regards to EURIBOR, and Japan with regards to TIBOR.
The table below provides a summary of the different approaches taken by the key IBOR jurisdictions.
How will the 2006 ISDA Definitions be amended?
The 2006 ISDA Definitions currently provide for specific fallbacks if particular floating interest rate benchmarks become unavailable while market participants continue to have exposure to that rate. These fallbacks ordinarily require the counterparty to obtain quotes from major dealers in the relevant interdealer market. However, if an IBOR is permanently discontinued, it is generally agreed that the current approach would be cumbersome to apply and could generate significant market disruption. Major dealers may simply be unable to give such quotes or the quotes would significantly differ across the market.
The Supplement will therefore replace these fallbacks with new fallbacks that will come into effect on a temporary or permanent discontinuation of the relevant IBOR. In addition, in the case of LIBOR – related floating rate options, the fallbacks will be triggered upon a determination by the FCA prior to the permanent discontinuation of LIBOR that LIBOR is no longer capable of ‘being representative’ or is ‘non-representative’ of the underlying market and economic reality. A ‘permanent discontinuation’ is defined in the Supplement as an ‘Index Cessation Event’ (see further discussion below).
The fallback rates are adjusted versions of the RFRs referenced in the above table. To determine an adjusted RFR, the underlying RFR is compounded over an accrual period corresponding to the tenor of the IBOR. The reason for this compounding is that RFRs are overnight rates, whereas IBORs are term rates which take account of the periods over which the payments are calculated. As a result, term adjustments need to be made to the replacement RFRs by compounding the relevant RFR in arrears over the relevant period.
A spread adjustment will then be added to the adjusted RFRs to ensure the underlying contract which references an IBOR continues to function as closely as possible to what was intended. These adjustments reflect the fact that IBORs are available in multiple tenors and incorporate bank credit premiums and other factors (including liquidity) that overnight RFRs do not. To determine the spread adjustment, the median spread between the IBOR and the adjusted RFR is calculated for the relevant tenor over the five-year period preceding an announcement constituting an ‘Index Cessation Event’ (as defined below). The spread adjustment will be calculated for each rate on an indicative basis until an Index Cessation Event occurs, after which it will fix for the remaining payments over the term of the transaction.
The sum of the adjusted RFR and the spread adjustment is defined in the Supplement as the “Fallback Rate”. ISDA has selected Bloomberg to calculate and publish the above adjustments to the RFRs together with the Fallback Rate.
Another key structural difference between RFRs and IBORs is that IBORs are forward-looking rates, meaning they are set at the beginning of the interest period. Whereas RFRs are backward-looking overnight rates and therefore calculated at the end of the period. This means that interest payments cannot be known in advance of the payment date, which may create operational issues and uncertainty for both the payer and the payee. The Supplement addresses this issue by creating an ‘Observation Period’, that commences two business days prior to the relevant calculation period and ends two business days prior to the payment date (defined in the Supplement as the ‘Fallback Observation Day’), leaving sufficient operational time for the parties to calculate and make the payments due on the payment date.
Other adjustments made to accommodate the backward-looking nature of RFRs include the requirement that although the Fallback Rate must be published on the Fallback Observation Day, the Fallback Rate used will be the Fallback Rate published on that day in respect of the ‘Original IBOR Rate Record Day”, being the date that corresponds with the date on which the rate would have been obtained under the original contract terms. For certain IBORs (e.g., BBSW and GBP LIBOR), this is the Reset Date under the 2006 ISDA Definitions, while for other IBORs (e.g., USD LIBOR), this date will fall two banking days prior to such Reset Date.
How will the changes affect floating rate options referencing Australian benchmarks?
The 2006 ISDA Definitions currently define a number of floating rate options for AUD derivatives. Of these, only the definitions for “AUD-BBR-AUBBSW”, “AUD-BBR-BBSW” and “AUD-BBR-BBSW-Bloomberg” will be amended by the Supplement. The amendments will require parties to determine a fallback rate for these BBSW-based floating rate options in the following scenarios:
- If the rate for the relevant period is not available by 12 noon, Sydney time but no Index Cessation Effective Date has occurred, the rate will be:
- a rate formally recommended for use by the administrator of BBSW; or
- if no recommendation is available, a rate formally recommended for use by ASIC (or any successor to ASIC in its role as supervisor of BBSW); or
- if neither of the above options are available, the calculation agent must determine a commercially reasonable alternative for BBSW, considering any rates used by central clearing counterparties and/or futures exchanges with trading volumes in derivatives or futures referencing BBSW that the calculation agent considers sufficient for that rate to be representative of the underlying market.
Permanent non-publication (Index Cessation Effective Date occurs)
- If an Index Cessation Event has occurred, the rate for any date occurring on or after the Index Cessation Effective Date will be deemed to be the “Fallback Rate (AONIA)”, being a term and spread adjusted AONIA rate as published on the relevant Bloomberg screen. “Index Cessation Event” and “Index Cessation Effective Date” are new general definitions that trigger fallback options for all floating rate options. In summary, an Index Cessation Event will occur if an “Applicable Rate” ceases to be published, or where the Applicable Rate is a LIBOR Rate Option (being Sterling LIBOR, Swiss Franc LIBOR, U.S. Dollar LIBOR, Euro LIBOR or Yen LIBOR), or the Applicable Rate ceases to be representative of its underlying market. The corresponding Index Cessation Effective Date will occur on the first date on which the Applicable Rate (in this case BBSW) is no longer provided, or in respect of a LIBOR Rate Option, the first date on which the Applicable Rate is non-representative.
Unavailability of fallback rate
- If an Index Cessation Event has occurred, BBSW will initially fall back to Fallback Rate (AONIA). However, if this is not available, further fallbacks will apply, first to AONIA, and then to the rate recommended as the replacement rate for AONIA by the RBA, in each case subject to appropriate term and spread adjustments.
- The Supplement requires fallback elections to be determined in equivalent scenarios for the other floating rate options that it amends.
IBOR Fallbacks Protocol
The Protocol will allow Adhering Parties to agree to amend their legacy derivative contracts with other adherents which reference the 2006 ISDA Definitions (or previous versions) or a floating rate option that is amended by the Supplement, as if they had incorporated the changes set out in the Supplement. It achieves this by replacing references to the original IBOR rate option with the revised IBOR rate option (incorporating the new fallbacks and triggers).
The Protocol will not only apply to ISDA documents but will automatically extend to certain non-ISDA documents (those that include references to key IBOR rates, including stock-lending and repo documentation such as the GMRA and GMSLA). Given this is a much wider range of documents than has been covered by previous ISDA Protocols, parties may wish to consider whether they should exclude any non-ISDA documents from the scope of the Protocol, particularly if they are subject to amendment restrictions, including third party consent requirements. If so, any exclusions will need to be agreed bilaterally between the parties.
Bilateral agreements relating to the Protocol
ISDA has published standard form agreements that can be used to bilaterally amend the scope or effect of the Protocol. These are intended to be between Adhering Parties or by Non-adhering Parties who have bilaterally adopted the Protocol, with modifications if required, or to amend the scope or effect of the Protocol either before or after adherence.
How have Australian regulators responded?
While adherence to the Protocol is voluntary, in a joint media release the RBA, APRA and ASIC, have strongly urged Australian institutions to adhere to the Protocol by 25 January 2021. The media release noted that timely adherence to the Protocol will greatly reduce the risks of contractual disputes and litigation through creating a consistent approach to fallback benchmark rates if LIBOR comes to an end.
Consistent with this, the RBA announced in late 2019 that it will be managing its own IBOR transition risks by requiring floating rate notes that reference BBSW to include the relevant ISDA fallback provisions in order to be to be eligible for the RBA's open market operations.
Australian conduct issues
The Protocol and the Supplement were informed by extensive consultation with industry groups, including the IBOR Transformation Australian Working Group (Australian Working Group) comprised of representatives from AFMA, the Commonwealth Bank of Australia, Westpac Banking Corporation, Australian and New Zealand Banking Group Limited, National Australia Bank and Macquarie Group Limited.
In December 2019, the Australian Working Group wrote to the Council of Financial Regulators requesting guidance on the supervisory expectation regarding conduct matters associated with the transition from IBORs to RFRs. The letter raised two issues - the first concerned conduct risk in relation to the transition to RFRs and the second concerned client communications.
In relation to conduct risk, the Australian Working Group observed that the complexity of transitioning to RFRs and asymmetry of understanding between banks and clients created a risk that financial services licensees may breach their obligations to treat all clients fairly in accordance with section 912A of the Corporations Act 2001 (Cth). Additionally, transitioning clients from LIBOR to RFRs in a potentially illiquid market, could involve considerable execution costs and give rise to opportunities for pricing biases to emerge. The Australian Working Group also noted that since the transition path from IBORs to RFRs is uncertain, it is difficult for financial service providers to develop a comprehensive client communications strategy so as to ensure that customers are appropriately informed about the LIBOR transition.
In response to the Australian Working Group’s letter, ASIC recommended that entities address conduct risk by:
- considering the connection between conduct and reward to ensure that providing a service does not come secondary to sales;
- addressing any imbalance of power and knowledge between them and their clients by providing effective communication and documenting of their decision-making process during the transition from LIBOR;
- acting in their clients’ best interests and ensuring effective conflict management protocols are in place to achieve fair outcomes for clients; and
- being held accountable for breaches of the law.
In addressing the client communications concerns raised, ASIC recommended that entities:
- not take a ‘one size fits all’ approach in delivering information, but rather tailor it to the sophistication of client segments and the complexity of the products and services;
- orient communications from the client’s perspective, by considering:
- the content that the client needs to be familiar with;
- the time at which the client would be most receptive to information;
- what the transition means for the client in practical terms;
- layering messages, so that the most relevant information is given to the client upfront; and
- making additional information repositories available;
- test communications and consider the best channels for delivery of messages; and
- be transparent in communicating information by disclosing developments in the industry and the impact they may have on the transition from LIBOR.
Financial service providers who intend to adhere to the Protocol or incorporate the Supplement Amendments from 25 January 2021 should take note of the above guidance when formulating their internal protocols for managing conduct risk or developing client communications strategies in relation to the Supplement Amendments or their Protocol adherence.
Next steps for derivatives markets
Following the release of the Supplement and the Protocol, market participants will have more certainty in relation to how derivatives fallbacks will operate and the way forward for new transactions and transitioning legacy transactions. At the same time, any risks inherent in the use of these fallbacks for new and legacy derivative exposures will need to be identified and appropriately managed, particularly in relation to the following:
- derivative transactions that hedge cash products (such as loans, bonds or asset-backed securities) – will the changes maintain the alignment between the triggers and fallbacks in both the derivative and the underlying cash product where appropriate or (in the case of legacy derivative contracts) require the consent of bondholders or lenders?
- derivatives that hedge other derivatives positions with counterparties that have not adhered to the Protocol - will this create any imbalances?
- "non-linear" derivatives (e.g., swaps with stubs or non-standard accrual periods, caps and floors, swaptions) – do any of these products need to be bilaterally amended to alter the impact of the Supplement Amendments?
Participants should also have regard to the RFR Conventions and IBOR Fallback Product Table published by ISDA which summarises how the IBOR fallbacks in the Supplement apply to a variety of different derivative products. The table suggests language for counterparties wishing to alter the impact of the fallbacks for certain derivatives products by bilaterally negotiating modifications to the standard payment dates, business day conventions, fixing dates, observation dates and reference days.
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