ISDA's IBOR fallbacks for interest rate and currency derivatives
Monday 25 January 2021 marked a key milestone in the journey mapped out by the International Swaps and Derivatives Association, Inc. (ISDA) to guide the derivatives markets through an orderly transition away from using benchmarks based on inter-bank offered rates (IBORs) and towards those that rely on risk-free reference rates (RFRs). It was the "go live" date both for Supplement number 70 (the IBOR Fallbacks Supplement) to the 2006 ISDA Definitions (the 2006 Definitions) and for the ISDA 2020 IBOR Fallbacks Protocol (the IBOR Fallbacks Protocol), ISDA initiatives designed to apply new rate fallbacks for key IBOR benchmarks across the derivatives market.
The new IBOR fallbacks provide a standardised safety net that activates upon the permanent cessation of publication of an IBOR benchmark, or upon the occurrence of pre-cessation trigger in respect of a benchmark based on the London Interbank Offered Rate (LIBOR), and provide a clear path forward for impacted transactions. In addition, for those EU and UK entities that are subject to a regulatory requirement to include robust written benchmark fallbacks in their contractual documentation, the UK Financial Conduct Authority (the FCA) has indicated the new IBOR fallbacks will tick that box.
However, amidst the fanfare around the new IBOR fallbacks going live, market participants should remember that these benchmark fallbacks are just that, fallbacks, and their implementation only represents one step in the transition process (albeit a critical one). Once robust fallbacks are in place, each market participant should also consider actively transitioning its portfolio of transactions to alternative rates in advance of the cessation of applicable IBOR benchmarks, giving themselves and their counterparties control over any adjustments to the economic terms. This client alert sets out some key considerations for derivatives market participants now that the new IBOR fallbacks have come into effect.
What has happened?
With effect from 25 January 2021, the IBOR Fallbacks Supplement applies by default to all transactions traded on or after that date and which incorporate the 2006 Definitions, although parties can still elect to explicitly disapply it in their confirmation (just like any other supplement to the 2006 Definitions). Going forward, this means that the new IBOR fallbacks will generally apply automatically to new interest rate derivatives. But that is only half of the solution. The IBOR Fallbacks Protocol, which first took effect for previously adhering parties on 25 January 2021, incorporates the new IBOR fallbacks into transactions between adhering parties with a trade date prior to that date, and together with the IBOR Fallbacks Supplement, enables the new IBOR fallbacks to be applied almost universally to applicable ISDA-documented interest rate derivatives.
As of the date of this alert, over 12,500 firms had already adhered to the IBOR Fallbacks Protocol. Based on these numbers, the FCA estimates that just over 85% of uncleared swaps referencing GBP LIBOR now have effective fallbacks in place (because both counterparties have adhered to the IBOR Fallbacks Protocol) and, consequently, around USD 245 trillion out of a total of USD 260 trillion of LIBOR-linked contracts are now covered by the new IBOR fallbacks. Once cleared derivatives and futures are taken into account, the FCA estimates that around 97% of GBP LIBOR interest rate derivatives are covered by effective fallbacks. In addition, it is likely that some market participants will have incorporated the new fallbacks into their legacy transactions on a purely bilateral basis, and so the actual proportion of transactions covered by the new fallbacks may be even greater.
What specifically do the new IBOR Fallbacks cover and why?
The IBOR Fallbacks Supplement and the IBOR Fallbacks Protocol introduce new fallback rates for key IBOR term rates defined in the 2006 Definitions, specifically rates based on LIBOR in each of its published currencies (GBP, USD, EUR, JPY and CHF), as well as the following IBORs: the Euro Interbank Offered Rate (EURIBOR), the Bank Bill Swap Rate (BBSW), the Tokyo Interbank Offered Rate (TIBOR), the Hong Kong Interbank Offered Rate (HIBOR), the SGD Swap Offer Rate (SOR), the Thai Bhat Interest Rate Fixing (THBFIX) and the Canadian Dollar Offered Rate (CDOR). For each of these IBOR benchmarks, its applicable fallback rate would apply in the event that, broadly, one or more of its tenors permanently ceases to be published or, in the case of a LIBOR benchmark, is no longer representative of the relevant underlying market.
The introduction of these new fallbacks remedies a significant issue with the original fallbacks in the 2006 Definitions, namely that those fallbacks were intended to apply only for short-term interruptions in the calculation of a benchmark rate. The effect of this deficiency was that the fallbacks generally would not work (or would produce a commercially unintended outcome) if the benchmark rate permanently ceased to be available, and this has been the basis of ongoing concern since Andrew Bailey's speech in July 2017 fired the starting gun for the transition away from LIBOR. This speech was prompted by concerns about whether LIBOR would continue to be representative of the interbank lending market it was intended to measure. Although this was worrying it itself, uncertainty about LIBOR being representative raised the possibility that LIBOR might be deemed non-representative under the EU Benchmark Regulation (Regulation (EU) 2016/101) and thereby become subject to restrictions on use by many EU regulated financial entities.
For more detailed information about the IBOR Fallbacks Supplement and the IBOR Fallbacks Protocol, please see our earlier client alert ISDA 2020 IBOR Fallbacks Protocol: What you need to know.
Can I still adhere to the IBOR Fallbacks Protocol?
Yes. The IBOR Fallbacks Protocol doesn't currently have a cut-off date for adherence and therefore continues to be open, although ISDA has reserved the right to close the protocol at a future date by specifying an adherence cut-off date with at least 30 days' notice. Irrespective of the date on which participants adhere, the IBOR Fallbacks Protocol only applies to transactions with a trade date prior to 25 January 2021, and transactions with a trade date on or later than this date will need to rely on the application of the IBOR Fallbacks Supplement.
Does this mean I'm nearly done with my IBOR transition work?
Probably not. Although the coming into effect of the new IBOR fallbacks was a key milestone in the transition away from using IBORs, it is important to assess the impact that these new fallbacks will have on trades when they are applied following a particular IBOR being discontinued. For new transactions, many market participants are actively looking to use the new RFRs directly in transactions in place of IBORs (which will avoid the need to apply the fallbacks on the occurrence of such an IBOR discontinuation). In both cases, participants will need to consider whether the fallbacks or directly referenced RFRs will produce the desired result for their transactions and how these transactions will work when linked to other instruments, such as bonds or loans, which may have different or competing fallback provisions.
What about my legacy book?
As a first step, to the extent your organisation has not done so already, you should consider adhering to the IBOR Fallbacks Protocol or bilaterally incorporating the new IBOR fallbacks into your legacy trades with your counterparties so that the new pre-prescribed fallbacks are in place. You can check the list of adhering parties on the ISDA website to determine whether any particular counterparty has adhered already to the protocol, as it may be useful to clarify the proportion of your portfolio that could benefit from adherence.
Although the IBOR fallbacks are a helpful mechanism to provide some degree of future-proofing for transactions, market participants should not be relying solely on these as the primary method for implementing their IBOR transition. More targeted amendments for individual transactions, or groups of them, should be considered and, where relevant, agreed proactively with your counterparties. IBOR fallbacks developed by ISDA as a "one size fits all" solution for use by the entire derivatives market are not necessarily going to be the best solution (or even a good one) for any particular transaction or market participant, whereas amendments agreed between the parties can be tailored to account for the specifics of that transaction, better reflecting the commercial expectations of the parties and avoiding any material transfer of economic value. In addition, when making customised amendments to derivative transactions, market participants with linked cash products should particularly consider how the relevant derivatives transactions interact with these. Fallback provisions in these cash products are unlikely to fully align with the new IBOR fallbacks incorporated into derivative transactions, and agreeing customised amendments may be necessary to ensure these linked products remain aligned in respect of both the principal benchmark and any fallback rates.
What is happening next?
ICE Benchmark Administration Limited (IBA), the administrator of LIBOR, published a consultation last month, which closed on 25 January 2021 as well, proposing timeframes for the cessation of its calculation and publication of certain LIBOR tenors. The consultation set out IBA's proposal that all tenors of LIBOR for all currencies other than USD LIBOR would cease from 31 December 2021, as would USD LIBOR for one week and two week tenors. For the other tenors of USD LIBOR (overnight, one month, three month, six month and twelve month tenors), the IBA proposed to cease publication from 30 June 2023.
The IBA will next confirm to the FCA how it intends to proceed, taking into account the responses received to its consultation. The FCA has said that, despite the later end date proposed for certain USD LIBOR tenors, the IBA consultation paves the way for future announcements on all five currencies being made simultaneously. We expect the FCA to make a formal statement about cessation/pre-cessation very soon, and this is likely to address the timing of a future announcement that a LIBOR benchmark is no longer representative or will cease being published by IBA. The FCA is also likely to confirm that any such cessation or non-representative determination is unlikely to take effect before the end of this year. Edwin Schooling Latter, Director of Markets and Wholesale Policy at the FCA, has recently said that the FCA cannot provide a specific date for any such announcement but that the FCA "sees no case for delaying decisions or announcements beyond the time necessary properly to assess the consultation responses that have now been received. Whether the relevant currency-tenor setting is subject to a cessation announcement, a pre-cessation announcement, or indeed both, announcements covering all settings could be made on the same day."
Upon the occurrence of an FCA announcement in relation to the timing of a future permanent cessation of, or non-representative determination for, any LIBOR benchmark (even if such announcement is made now), the spread adjustment component of the new fallback rate for that LIBOR benchmark would be fixed from the date of that announcement, even though it may still be many months before the date on which the actual cessation or non-representative determination occurs, being the date from which the fallback rate would apply. This is important because the market may have a substantial period of time, several months or more, to consider the impact of the new spread adjustment and update any relevant infrastructure and systems. Market participants should ensure they take advantage of this lead time.
Although the FCA has previously confirmed the participation of the current panel banks until the end of 2021, it is worth keeping a watch on this because any change to bring forward the expected date of a cessation or non-representative determination would reduce the available time remaining for market participants to complete their IBOR transition (particularly for those rates and tenors likely to disappear at the end of the year).
The FCA is also expected to consult market participants on its proposed new powers in the Financial Services Bill to publish LIBOR on a synthetic basis after it has become non-representative, but only for use in legacy transactions. In particular, the FCA will seek feedback on which legacy contracts should be permitted to use a synthetic LIBOR benchmark and the circumstances in which the use of a critical benchmark that has not yet ceased publication, such as those USD LIBOR tenors likely to be published until June 2023, should be restricted.
What else to look out for?
ISDA is currently working on a new set of interest rate definitions, the 2021 ISDA Interest Rate Definitions (the 2021 Definitions), which are expected to be published in May, ahead of adoption in June 2021. The 2021 Definitions will incorporate the new IBOR benchmark fallbacks, as well as updates to other parts of the 2006 Definitions, for example, in respect of disputing calculation agent determinations. The 2021 Definitions are intended to fully replace the 2006 Definitions for new derivatives entered into following their publication. The final form of the 2021 Definitions is very much a moving target over the next few months, so it is advisable to keep up-to-date with developments in this area as much as possible, particularly as the publication of the 2021 Definitions is pegged to be the most wide-reaching development to derivatives product documentation since the "big bang" and "small bang" for credit derivatives in 2009.
As always, please reach out to your usual Hogan Lovells derivatives contact if you need any information or advice on any of your IBOR transition plans.
This note is for guidance only and should not be relied on as legal advice in relation to a particular transaction or situation. Please contact your normal contact at Hogan Lovells if you require assistance or advice in connection with any of the above.
Authored by Jennifer O'Connell, Isobel Wright and Nicholas Watmough