IBOR Transition: What’s the Protocol for Derivatives?

Introduction

In connection with the anticipated discontinuance of LIBOR and similar benchmarks, the International Swaps and Derivatives Association (ISDA) has published the 2020 IBOR Fallbacks Protocol (Protocol) to help market participants deal with the orderly amendment of their swaps and other agreements referencing affected benchmarks. Derivatives transactions often reference an interbank offered rate (IBOR), and their upcoming cessation or lack of representativeness will require market participants to consider amending legacy contracts to account for the relevant IBOR’s successor rate and any applicable adjustments. This alert describes the functioning of the Protocol, the amendments made via supplement to the 2006 ISDA Definitions commonly incorporated into swap transactions, and the main issues market participants will have to consider when deciding whether to adhere.

Key Takeaways

• The Protocol allows for new fallback rates to apply upon key trigger events across a wide range of trading documentation.
  
  
• The new fallback rates consist of a risk-free rate (compounded in arrears) and a spread adjustment, to be calculated and published by Bloomberg.
  
  
• ISDA’s approach provides counterparties with both an efficient solution (via the Protocol) and the flexibility to decide on bilateral variations (including the disapplication of certain trigger events).
  
  
• The migration to a risk-free rate may have implications for the value of the underlying products, and counterparties should understand any value transfer and other ramifications before adhering to the Protocol.
  
  
• Fallback to risk-free rates will inevitably create mismatches between cash and derivatives products, or otherwise across the trading book. Market participants should identify and seek to mitigate the negative consequences of those mismatches.

The Protocol and 2006 Definitions Supplement

Following an industry-wide consultation, ISDA is proposing an approach that enables counterparties to implement uniform amendments to the IBOR components of their transactions via a Protocol, or agree to such amendments bilaterally, e.g., in respect of specific master agreements, credit support documents, or master or stand-alone confirmations entered into with a specific counterparty. With respect to certain LIBOR rates,^[1] the Protocol also provides for the fallback rates to apply (unless market participants elect otherwise) upon the occurrence of a pre-cessation “non-representativeness” event, essentially defined as a statement by a regulatory authority that the counterparties may no longer rely on the relevant benchmark as representative of the underlying market or economics that the relevant IBOR is intended to measure.

The Protocol provides for changes to be incorporated in respect of a “Protocol Covered Document” (as defined in the Protocol) in two circumstances: first, where such Protocol Covered Document references a “Relevant IBOR,” and second, where such Protocol Covered Document references a rate linked to or based upon a Relevant IBOR.  

The amended 2006 Definitions have been published as a stand-alone supplement that will also apply to new transactions going forward. In addition to the 2006 Definitions, the Protocol provides for corresponding amendments to the 2000 Definitions, the 1991 Definitions and the 1998 Supplement to the 1991 Definitions that have now been largely replaced by the 2006 Definitions. Other changes are set forth in an attachment to the Protocol, reflecting harmonizing amendments both to the other sets of ISDA definitions and to any stand-alone references to a Relevant IBOR incorporated in a covered transaction. Those amendments are intended to align rates terms so that any reference (whether deemed or explicit) to a Relevant IBOR in a Protocol Covered Document will result in the same fallback terms being applied consistently across trades.  

Optionality and Flexibility

While the Protocol’s reach is quite broad, it also provides a fair amount of flexibility and, with the use of additional template language to be published by ISDA, can be functionally adapted to suit the needs of counterparties. For example, the Protocol allows for the parties to amend not just their existing ISDA documentation but also additional master agreements and credit support documents to be specified by the parties (e.g., a repo or prime brokerage agreement), thereby aligning IBOR references and fallbacks across their trading documentation. Also, counterparties may bilaterally agree to exclude certain ISDA agreements that would otherwise be subject to the Protocol or disapply the pre-cessation triggers (see below). ISDA intends to publish template language for such bilateral agreements, as well as sample dispute resolution provisions for any determination to be made by the calculation agent pursuant to the terms of the Protocol.

Structurally, and in keeping with precedent, the Protocol allows for an agent to adhere on behalf of its clients. Agents may adhere on behalf of all entities they represent or with respect to only specific entities, and the list of relevant entities is not required to be uniform, meaning an agent may adhere on behalf of a different universe of entities with different counterparties.

The fact that the Protocol is designed to implement specific changes to transaction terms necessarily raises the question of the terms that will apply in the event of a novation. The transaction terms as amended via the Protocol remain in place for the life of the transaction, and continue to apply even if the transaction is subsequently novated to a non-adhering party or governed by a master agreement that is not itself a Protocol Covered Document. Similarly, a transaction whose terms were not amended that is then novated to an adhering party will remain subject to its preexisting terms.  

Triggering Events

The newly proposed fallback rates are intended to apply in the event of an “Index Cessation Event,” which is defined to mean (i) a permanent cessation, i.e., a public statement by either the rate’s administrator or a relevant regulatory authority that the applicable rate will no longer be provided by either its current or a successor administrator, or (ii) with respect to certain LIBOR rates, a pre-cessation, i.e., a public statement by the relevant regulatory authority that the relevant LIBOR rate no longer reflects the underlying market and economic reality of that LIBOR. Notwithstanding the forward-looking nature of these trigger events, the relevant fallback rate would only apply upon the “Index Cessation Effective Date,” which is the first date on which the applicable rate is no longer provided, or in the case of a pre-cessation event, the date on which the relevant LIBOR actually becomes non-representative (as specified by the applicable regulator). The application of fallback rates is prospective, such that if an Index Cessation Effective Date occurs following the Reset Date, the original rate would continue to apply for the duration of the relevant calculation period, and the fallback rate would only begin to apply on the next Reset Date or, with respect to the amended rate options denominated in USD,^[2] EUR and JPY, the next Reset Date occurring at least two business days after the Index Cessation Effective Date. In the event a rate calculation method relies on or references a period during which such rate was both provided and not non-representative but the rate has ceased to be published as of the calculation date, then the Index Cessation Effective Date would be adjusted to permit the previously published rate to be taken into account.

Fallback Rates

As a general matter, the approach taken by ISDA has been to amend only those rate options that are made available pursuant to a public source that explicitly recognizes such rate as reflecting the relevant LIBOR (or EURIBOR) rate. As a result, the amendments to the various rate options in the 2006 Definitions are strictly limited to those defined terms that reference a LIBOR (or EURIBOR) screen. Thus, for example, a swap transaction referencing “GBP-LIBOR-Reference Banks” remains unchanged, as such rate option, as defined, requires the solicitation of the Reference Banks but does not rely on the published LIBOR rate.

As originally set forth in the 2006 Definitions, the terms of the aforementioned rate options would have allowed for the parties to substitute a rate (based on the average of at least two quotes solicited by the Calculation Agent from certain reference banks) in the event the relevant rate was not published by the relevant administrator or otherwise made available by the first day of the relevant calculation period. As amended, each rate option referencing a LIBOR (or EURIBOR) screen eliminates this procedure and instead incorporates a predetermined fallback rate^[3] based on a specific overnight borrowing rate (also known as a risk-free reference rate (RFR)) identified by the industry and relevant regulators in respect of the relevant currency. In the event that a fallback rate would in turn also cease to be published, the amended rate options terms provide for further fallback rates to apply. As a general matter, the waterfall provides for the original fallback rate to fall back to, first, the rate either administered or recommended by the relevant monetary authority as the fallback rate’s first successor, and then — if such rate is not available — a bank rate used by such monetary authority and further adjusted by the Calculation Agent.^[4]

Also, because the amended 2006 Definitions only take into account the cessation of published LIBOR (or EURIBOR) rates with respect to a limited subset of currencies,^[5] any future cessation of a published rate referencing a non-LIBOR (or EURIBOR) screen (for example, “MYR-KLIBOR-BNM,” which is the screen reference for the Malaysian interbank offered rate) would not be addressed by the amended terms. In those cases, any fallback rates, including terms for their application, would need to be agreed bilaterally by the counterparties.

Fallback Adjustments

Because overnight RFRs, unlike LIBOR rates, lack a term structure and credit component,^[6] certain adjustments will be made to more closely align with the affected IBOR. Based on ISDA consultations, the published RFRs will be compounded in arrears over an accrual period corresponding to the relevant tenor. The rate will then be further adjusted by a credit spread that will be either added to the applicable RFR or accounted for via a one-time payment equal to the value transfer at the time the fallbacks become effective. This spread adjustment is based on the median difference between the relevant IBOR and the compounded RFR over a static five-year lookback period prior to the public announcement or publication triggering the fallback provisions. The adjusted RFRs, applicable spread adjustments and resulting fallback rates (comprised of the sum of the adjusted RFR and spread adjustment) will all be published by Bloomberg.^[7]

Changes to Certain Rate Options Tied to LIBOR

Additionally, the amended 2006 Definitions modify two rate options, one in respect of Singapore dollars and the other in respect of Thai baht, whose terms themselves do not directly reference a LIBOR (or EURIBOR) screen but nevertheless rely on the published LIBOR for U.S. dollars as an underlying reference rate.^[8] As amended, in both instances the fallback rate is calculated by reference to SOFR, as the fallback rate for U.S. LIBOR. With respect to the relevant rate option for Singapore dollars, an additional fallback rate has been incorporated using the Singapore Overnight Rate Average (SORA), although any potential spread adjustment needed to account for potential differences in term structure or tenor as between SORA and the fallback rate (based on SOFR) would need to be determined by the Calculation Agent as this would not otherwise be made available. No fallback rate or successor administrator for the Thai baht synthetic rate (e.g., as a stand-alone rate) is initially contemplated.

Calculation of Rates for Different Tenors and Maturities

Outside the context of a potential cessation of a LIBOR (or EURIBOR) rate, it is also possible that a rate for a particular nonstandard period or tenor might be unavailable or discontinued altogether. In such case, the parties would need to agree on a method for establishing the applicable rate. A newly added Section 8.5 to the 2006 Definitions allows for interpolation in respect of discontinued rates to apply when the only IBOR tenors available are not all either longer or shorter than the length of the relevant calculation period. Pursuant to Section 8.6, the discontinued rate would be determined either by reference to Linear Interpolation terms, if specified as applicable by the parties, or by interpolation of the nearest long rate (i.e., the rate applicable to the nearest longer calculation period for which a rate is available) and the nearest short rate (similarly determined). 

Consistent with the approach for determining discontinued or unavailable rates in Section 8.5, provisions have been added to the Linear Interpolation terms of the 2006 Definitions to address a scenario where the rate for a particular calculation period is unknown as of the end of the Calculation Period or the relevant payment date. The interpolated rate is calculated by reference to two rates with standard tenors, one of whose tenor is often longer than the length of the calculation period. As the new fallback rates reference overnight rates, however, the relevant rate for the longer tenor will not be known until the end of that tenor period in the event the fallback rates are triggered. In that event, interpolation of the nearest IBOR tenors shall apply. If that is not feasible (e.g., because the only remaining IBOR tenors are all shorter or longer than the applicable calculation period), then the risk-free rate will be compounded over the length of the relevant period and an adjustment spread will be added, as determined by the Calculation Agent based on an interpolation of the spread adjustments applicable to the tenors originally specified or used for the purposes of linear interpolation.  

Clearinghouse Discounting and Price Alignment Interest Switch

In addition to the transition away from IBOR, various clearinghouses have replaced the Effective Federal Funds Rate (EFFR) with SOFR for calculating interest (referred to as price alignment interest (PAI)) accruing on variation margin for certain covered products (such as USD interest rate swaps) and for calculating the net present value of the covered derivatives contract (based on discounted future swap cash flows). Although no cessation is planned for EFFR, a transition to SOFR was nevertheless considered critical to boost SOFR’s liquidity and use in derivatives markets (since dealers typically hedge their discounting liabilities). The Chicago Mercantile Exchange (CME) and the London clearinghouse (LCH) have both effectuated the transition as of mid-October of 2020. As compensation to account for any value transfer resulting from the change in the discounting rate, market participants received a combination of cash and a basis (EFFR-SOFR) swap booked in their account, which they were able to cash out via an auction run by the clearinghouses.

Although the transition to SOFR discounting does not directly impact uncleared swaps, ISDA has published bilateral CSA amendment templates[9] that would override any interest rate definitions based on a different benchmark rate, thereby making SOFR the applicable reference rate for any interest amounts owed on variation margin transferred by the parties in respect of uncleared swaps under the applicable Credit Support Annex. The templates allow the parties to specify the date from which SOFR shall apply as well as the cash compensation amount to be paid, if any.

Next Steps and Adherence Considerations

Ahead of the cessation of USD LIBOR at the end of 2021, the Alternative Reference Rates Committee (ARRC) of the Federal Reserve Bank of New York has published certain recommended best practices for the industry in order to facilitate the transition from LIBOR, accessible here. Likewise, in July of 2019 the Securities and Exchange Commission had issued a public statement relating to LIBOR’s cessation and recommended market participants focus on a number of transitional issues for asset managers to consider.

ISDA has announced that the Protocol will become effective on Jan. 25, 2021, for adhering parties. While regulators are encouraging adherence to the Protocol, a number of considerations will need to be taken into account. Market participants will need to take inventory of their contracts, identify all trades that will be impacted and identify instances where a mismatch may be triggered by the fallback (such as where a derivative is used to hedge interest rate risk on a cash product).

Counterparties should educate themselves on the ramifications of the changes, including in terms of liquidity and value transfer, as certain products (such as nonlinear derivatives) may be affected to a greater extent and justify requiring some form of compensation to account for the transfer of value. Market participants may not be able to do so before the spread adjustment has been determined by Bloomberg, which may well be after the Protocol becomes effective.

To the extent borrowers have entered into hedging transactions in respect of corporate credit facilities or bonds, they may want to consider the mismatch between the fallback provisions in their loan agreements and the ones implemented via the Protocol. This may require them to approach lenders proactively to avoid any mismatch between their debt documentation and related hedges.

Finally, counterparties should confirm that their operations and any third-party technology support vendors are in a position to complete all necessary enhancements to support SOFR when the transition is triggered. 

^[1] _{Applicable only to Sterling LIBOR, Swiss Franc LIBOR, U.S. Dollar LIBOR, Japanese Yen LIBOR and Euro LIBOR.}

^[2] _{The same would be true for rate options in respect of Singapore dollars and Thai baht, as further discussed below.}

^[3] _{These overnight rates are as follows: (i) for sterling (GBP), the Sterling Overnight Index Average (SONIA); (ii) for the Swiss franc (CHF), the Swiss Average Rate Overnight (SARON); (iii) for U.S. dollars (USD), the Secured Overnight Financing Rate (SOFR); (iv) for both euros (EUR) and EURIBOR, the Euro Short-Term Rate (EuroSTR); (v) for Japanese yen (JPY), the Tokyo Overnight Average Rate (TONA); (vi) for Australian dollars (AUD), the Australian interbank overnight cash rate (AONIA); (vii) for Canadian dollars, the Canadian Overnight Repo Rate Average (CORRA); and (viii) for Hong Kong dollars (HKD), the Hong Kong Dollar Overnight Index Average (HONIA).}

^[4]_{For example, the U.S. LIBOR terms prescribe the use of, first, the Fed Recommended Rate (essentially the fallback rate recommended as the replacement for SOFR), or, if such rate is unavailable, the Overnight Bank Funding Rate (OBFR) provided by the Federal Reserve Bank of New York, or finally, if the latter is also unavailable, the short-term interest rate target set by the Federal Reserve, as adjusted by the Calculation Agent to account for any differences between the Fed Recommended Rate, the OBFR or short-term interest rate, as applicable, and the previously applicable fallback rate. In the case of GBP LIBOR, the fallback for SONIA would be first to the GBP Recommended Rate (i.e., the rate recommended to replace SONIA) and then to the bank rate recommended by the Bank of England, adjusted accordingly by the Calculation Agent.}

^[5] _{See footnote 3.}

^[6] _{This is primarily because an overnight borrowing rate such as SOFR only accounts for overnight risk with respect to collateralized exposures, while LIBOR (or EURIBOR) is intended to reflect borrowing risk on an unsecured basis over an extended period of time and therefore incorporates a bank credit risk premium.}

^[7] _{Additional information on the methodology for calculating the fallback rates as well as the transition to their use and application is described in https://data.bloomberglp.com/professional/sites/10/IBOR-Fallbacks-Fact-Sheet.pdf and the IBOR Fallback Rate Adjustments Rulebook published by Bloomberg and available here.}

^[8] _{“SGD-SOR-VWAP” and “THB-THBFIX-Reuters” are actually synthetic rates representing the cost of borrowing U.S. dollars and swapping them out for Singapore dollars or Thai baht.}

^[9] _{Available at https://www.isda.org/2020/05/11/benchmark-reform-and-transition-from-libor/#related.}